Tax Efficient Portfolio Management
There are several ways to help reduce taxes and improve after-tax returns for investors. Perhaps the most common approach is “asset location,” which involves placing the least tax efficient assets, those that generate taxable income instead of capital gains, in tax-deferred accounts (IRAs, 401(k)s, or annuities). For most investors, ordinary income (interest and non-qualified dividends) is taxed at a higher rate than long-term capital gains. Investors can take cash from their tax-deferred portfolios on their own schedule. In many cases, it’s best to draw funds after retirement when most investors typically fall into a lower tax bracket. Therefore, investors can defer paying taxes on income or gains until money is taken out of the portfolio and can plan on timing the withdrawals at the most advantageous tax rates. The result is permanent tax savings.
Another approach is to evaluate the after-tax return on each investment and emphasize those that produce the highest expected return. Investors in higher tax brackets (federal and/or state) can benefit from holding municipal bonds that provide attractive after-tax returns. Most municipal bonds offer income that is not taxed at the federal level. In addition, for investors living in states that have an income tax, it may be optimal to purchase state-issued municipal bonds whose income may be excluded from state taxation. By comparing the after-tax rate of return of taxable and municipal bonds, investors can determine the option that maximizes their after-tax returns.
In addition to bonds, stock returns are also impacted by federal and state taxes. Holding an appreciated stock for at least one year and a day before selling ensures gains are taxed at the long-term capital gains rate, which is lower than the rate applied if the stock is sold before its one-year holding period. The maximum federal long-term capital gain rate is 20% while the maximum short-term capital gain rate is the same as the ordinary income rate of 39.6%. For high-income taxpayers, the long-term capital gains rate could save 19.6% versus the short-term rate. The taxpayer must also consider the impact of the 3.8% net investment income tax, which applies once investment income reaches a certain threshold. Timing a sale in a year where income is lower can result in permanent tax savings.
Some asset classes are generally more tax efficient than others. For example, actively managed small-cap stock funds tend to purchase and sell stocks more frequently than large cap funds. By considering portfolio turnover, which measures how often stocks are purchased and sold, you can estimate what percentage of potential gains will be short-term in nature versus long-term. Funds that have a high portfolio turnover ratio are less tax-efficient and should be held in tax-deferred accounts or excluded from the allocation if a tax-deferred account is not available. In addition, some alternative strategies, such as a total return mandate, are not tax efficient as the managers are attempting to achieve a positive return in any market environment regardless of the impact of taxes. Therefore, swings in market momentum can result in frequent trading and significant changes in portfolio holdings.
Tax loss harvesting is a strategy to sell a security in a taxable account when its price is below its cost and capture a loss. By realizing the loss, investors can use the capital loss in the future to offset portfolio income and gains and reduce the tax liability. Subsequently, a similar security is purchased so the overall asset allocation remains consistent and expected returns are not impacted. Therefore, tax loss harvesting doesn’t materially change a portfolio but provides a tax benefit. Regardless of whether the market subsequently moves higher or lower, the realized loss can be used to reduce taxes in the current year or future years.
When a mutual fund sells a position for a gain they are required to distribute the gain to shareholders. Likewise, when a fund sells a position for a loss, a capital loss occurs. Keep in mind that when investors purchase a fund they are assuming the original cost basis of the holdings and when positions are sold the gain or loss is calculated using the original cost basis, regardless of when the mutual fund shares were purchased. Mutual funds are not taxable entities, but the tax burden is passed on to holders of the funds. If over the course of a year a fund experiences positive net gains (realized gains exceed losses), these gains are traditionally distributed to shareholders in late November or December and the individual is responsible for paying any corresponding taxes.
When profit is distributed to shareholders as a capital gain the fund’s price is reduced by the amount of the distribution. Although the fund’s price declines, the shareholder either receives the distribution in the form of cash or it is reinvested and more shares are purchased. If the gains are reinvested, which is most common, the investor has more shares, and despite the lower price, the value of position is unaffected by the distribution. Although the fund’s return isn’t impacted by the distribution, if taxes are paid the net return to shareholders is reduced by the tax liability.
Fund companies begin projecting their capital gain distribution estimates in November. At that time, they provide data that indicate the size and the date of the projected distributions. In situations where the fund’s capital gain distribution is larger than the unrealized gain or loss of the holding, selling the fund and taking the smaller gain or loss generates the best tax result. As is the case with tax loss harvesting, a similar position is purchased and the overall asset allocation remains consistent.
We strive to be as tax-efficient as possible. We employ all of these strategies in our portfolio construction and trading processes. Tax savings may seem minimal, but when compounded over time they can be significant. We understand that it’s not what you make, but what you keep that matters most.
Still have questions? Contact us to discuss your individual circumstances. We’d be happy to have our advisors help you find the answers you seek.
