Optimizing your Trading Strategy
For those of you who faithfully follow The Prudent Investor’s Model Stock Portfolio, you will notice that the recommended percent ownership for a given stock will change from month to month, as shown by the Target Ownership column in Table 2. This ranking is generated using our proprietary ranking system, which takes into account the valuations of all the stocks in the portfolio relative to one another. Generally speaking, when one stock moves up strongly (or down strongly) in price relative to the other stocks, our model will call for us to buy or sell additional shares. This approach tends to create a structured “buy low and sell high” outcome, where we are forced to add more shares to our position when a stock falls in price, and likewise forced to sell shares as the stock price moves higher.
All this trading can make it more difficult to generate long-term capital gains in your taxable accounts. Long term capital gains (i.e., gains generated once you’ve held a security for at least 12 months) are taxed at a top rate of only 15% on the federal level, as opposed to short-term capital gains that can be as high as 35% (federal rate). Add state taxes on top of that, and the tax bite can really hurt.
One way to help reduce the amount of short-term gains you generate each year is to coordinate your buy/sell activity between your IRA and taxable accounts. Assuming you have this flexibility, such an approach can greatly aid the timing of taxable consequences. An example of how such a coordinated trading method works is as follows: consider purchasing approximately 1/2 of the required number of shares of a given stock in your tax-sheltered account and the remaining half in your taxable account. If the Model Stock Portfolio later calls for you to sell some (but not all) of the shares, sell shares first from your tax-deferred account. In doing so, you do not generate any taxable gains. It is not uncommon for a given stock in our model to see several additions and subtractions to the number of shares owned while the stock remains on the list. Taking your gains in your tax-deferred account first allows you to follow the model but still reduce your tax bill at year-end. In the best case, you will be able to hold the initial shares you purchased in your taxable account for the full 12 months, long enough for them to qualify for long-term capital gain treatment.
Note that not all stocks are created equal, and thus you may not wish to do this with every single stock in the model. This strategy works best with more volatile stocks, such as NTRZ, WHIT, and ICOC, as well as other small-cap and micro-cap stocks where market swings can be quite large over short periods of time.
Tax Optimization for Dividend Paying Stocks
All else being equal, however, you should tend to prefer keeping 100% of your shares of REITs (Real Estate Investment Trusts) in your tax-deferred account. A large percentage of the total returns generated from REITs comes from the fat dividends they pay out each year. For tax purposes these dividends are considered “ordinary income,” even though they are called “dividends.” Ordinary income is taxed just like other income you earn from your employer, meaning tax rates can be as high as 35% on the federal level. Examples of REIT stocks in our portfolio paying out attractive dividends that would be ideal candidates for holding in a tax-deferred account include DFR, PCAP, and PCC (all of which pay out more than 8% annually in dividends).
On the other hand, it can be generally preferable to keep traditional dividend-paying stocks (i.e., non-REITs) in your taxable account rather than your tax-deferred account, especially those that pay more attractive dividends. Why? Because dividends paid out from such stocks are currently taxed at the same rate as long-term capital gains, the most favorable rate for gains. Granted, paying no taxes is better still, but as a strategy for deciding which stocks to purchase in which accounts, keeping these non-REIT stocks in your taxable account and REIT stocks in your tax deferred account is optimal.