A Publication of WTVP

Albert Einstein once noted, “The hardest thing in the world to understand is the income tax.” Since Congress fatefully ratified the 16th amendment in 1913 legalizing the income tax, entire industries and professions have been born to eliminate and defer tax. Taxes are one of the single largest and most controllable costs of investing.

While ignoring taxes was easy in the double-digit return era of the 1990s, reducing taxes in today’s lower return environment is more important than ever. A recent study confirmed this. Amazingly, over 30 years, the average mutual fund investor lost a whopping 58 percent of his or her cumulative return to taxes. While a $1 investment grew to $21.89 for a tax-free investor, the taxable investor with identical holdings accumulated just $9.87.

In the past, the investment industry and academia have largely ignored tax implications, and instead, focused strictly on risk and return. Tax-efficient investing adds tax ramifications as the critical third leg to the investment management stool (risk/return/taxes). This is a complex concept. Tax-efficient investing deals with constantly changing tax laws, multiple types and rates of tax, the continual battle between tax strategists and fickle politicians, and the added complexity of state and local taxes.

The secret to tax-efficient investing is having a dynamic and systematic process to structure your portfolio for maximum tax efficiency. It must recognize that today’s tax situation will probably be different tomorrow. You must constantly adjust your tactics to new realities. The process involves optimizing a suite of tax tools to take advantage of current and future tax benefits.

In developing this process and suite of tax tools, investors need to understand that there are three primary investment strategies to reduce or eliminate tax. They include:

  1. Permanent elimination of taxes
  2. Deferral of taxes into future years, and
  3. Deliberately timing the recognition of income to low-rate years.

Tax-efficient investing focuses on portfolio structure as well as low turnover, broad diversification and adherence to a long-term buy and hold strategy.

Many investors mistakenly assume that owning mutual funds results in higher taxes. This is a myth. While it is true that most actively managed funds, and even some index funds, frequently trigger unnecessary tax, most index and exchange traded funds (ETFs) are extremely tax-efficient. In particular, tax-managed index funds avoid many of the common tax traps associated with traditional funds while taking advantage of the established tax law to accomplish optimal tax efficiency.

Tax management techniques defer taxes to the future. Deferring tax is like getting an interest-free loan from the government to be repaid at your option—generally when you are in a lower tax bracket. Though tax-management techniques may slightly increase costs and portfolio turnover, and introduce tracking error, they increase after-tax returns by significantly more than they increase costs.

Six Tax-Management Techniques

  1. Expand capitalization range
  2. Employ “hold” range
  3. Convert short-term gains to long-term by holding more than 12 months
  4. Harvest losses to offset capital gains
  5. HIFO (Highest in, first out) accounting method
  6. Penalty/transaction fees to discourage short-term trading.

In the quest for maximum tax efficiency, asset location is nearly as important as the actual investments you make. To understand, imagine that you hold your portfolio in three different tax buckets. The buckets catch and hold your growth. Still, some gains evaporate due to taxes, depending upon which bucket your money is in. This “tax bucket” analogy simplifies the myriad of tax rates, regulations, rules and types of income. The three most common tax buckets include tax-deferred accounts (i.e. traditional IRA, 401k, 403b, annuity and pension assets), taxable accounts, and Roth IRA accounts. By happenstance, some people have all their assets in one bucket, although most investors have them spread over two or more buckets. The Roth IRA bucket is often the smallest (since this is a newer type of account), while taxable and tax-deferred buckets are typically largest.

Most investors ignore tax consequences or don’t properly divide their investments among their accounts. Though effective tax bucket management is counterintuitive and complex, the benefits of getting it right are significant. Effective asset location does not increase your gross return, but reduces how much tax you pay on April 15th. You earn more by saving tax.

Tax engineering is an effective method of coordinating and assembling your assets to eliminate and/or defer unnecessary taxes. It focuses on getting the right investments, within your asset allocation strategy, positioned in the right tax buckets. This does not change your actual gross return; it just systematically reduces your tax bill and increases your after-tax return. Tax engineering is neither simple nor intuitive. It requires making investment decisions on a portfolio-wide basis and is a two-step process. First, investors must determine their overall asset allocation. This is based on risk and return preferences. The allocation decision determines the optimal combination of asset classes including large stocks, small stocks, bonds, etc. Step two then focuses on proper asset location—it determines which investments belong in which tax buckets.

Unfortunately, there are going to be losses along the way. Recognizing capital losses is never fun. While we would prefer to never lose money, as in contests and sporting events, you can’t win all the time. Growth-oriented investors occasionally suffer the agony of defeat. Happily, the investment world does offer taxable investors a consolation prize. Tax loss harvesting allows us to recapture some of the loss from Uncle Sam. Loss harvesting is not complex. Investors have the ability to control the timing and recognition of gains and losses. Successful investments can be held indefinitely—allowing long-term deferral of gains. In contrast, it is prudent to sell losing investments in order to get current-year tax write-offs. Importantly, this can only be done in taxable accounts (not in tax-deferred accounts, i.e. IRAs).

Ideally, losses are harvested in a disciplined and systematic manner that continually captures tax benefits and preserves them for current and future use. Any unused losses can be carried forward indefinitely to offset future gains. This counterintuitive process is mentally difficult, in that it requires investors to admit their losses by selling losers.

Investors can utilize a number of gifting and charitable strategies to reduce or eliminate deferred gains that build up over time. Most people don’t know that unrealized capital gains are completely forgiven at death. While long-term capital gains during life are taxed at rates of up to 15 percent, even the wealthiest Americans escape tax on unrealized capital gains at death. If Bill Gates sold his Microsoft stock tomorrow, he would pay 15 percent in capital gains tax on the sale. However, if Mr. Gates were to die and his family was to sell the stock after his death, the taxable gain would vanish. They would save the 15-percent capital gains tax—permanently! This permanent elimination of capital gains tax at death is referred to as the “step-up in basis” and is available to almost every investor. Benjamin Franklin once observed, “In this world nothing is certain but death and taxes.” For once, here’s a case where death at least eliminates one layer of tax!

Tax-efficient investors should remember several key rules, including:

We believe that tax-efficient investing requires a knowledgeable coach. Tax management may be the single most valuable contribution offered by an effective financial advisor. To add value, an advisor needs to use a disciplined, systematic and integrated process. Though tax-efficient investing might be easy to ignore in the short term, it is hugely beneficial over the long term. Getting it right may be the difference between success and failure in a long-term financial plan. iBi