Investing for Tax Efficiency
Posted on: February 7, 2014 by Martin Curiel, CFA in Tax Strategy
Taxes are boring. I’ve never been to a party where the words, “Let me tell you about my exciting Schedule A deductions" were uttered. It’s much more fun to talk about great stock picks or investments. Filling out complex forms to send to the IRS or state governments is no idea of fun for most people. Amidst a growing deficit and the need to fund social programs such as Obamacare, the “Tax Man” has become more aggressive over the last couple of years. We expect this trend to continue. For example, a high-income earner living in a state like California could pay close to 55% on dividends and short-term capital gains and as much as 35% on long-term capital gains. We agree that taxes are dry and cumbersome, but they need to be fully understood and continuously managed (not just in April!). At the end of the day, gross investment returns are of little value to the investor – after-fee, after-tax returns are what ultimately matter.
In our experience as advisors, most investors fail to integrate tax strategy with investment strategy
, and thus leave money on the table without fully realizing it. In this article, we will discuss the basics of investing for tax efficiency
. Based on our experience, there are 7
main strategies to build a tax-efficient portfolio:
1. Develop One Asset Allocation
– Many investors think in “buckets” – they have their high-risk account, low-risk account, play account, etc. Each one of these buckets has its own asset allocation – a mix of stocks, bonds, and even cash. While psychologically it might feel good to look at investments from this vantage point, it can introduce tremendous tax inefficiency. It’s best to come up with a single strategic asset allocation
, and then figure out the most tax-efficient way to meet that allocation. For example, if an investor decides on a 20% allocation to bonds – which generate interest that is taxed at the highest marginal tax rate – she would first place the bonds inside tax-sheltered accounts (e.g., 401(k)). Having a single allocation also reduces the complexity of monitoring for performance, costs, and taxes.
2. Maximize Contributions to Tax-Deferred Accounts
– These include 401(k)s, SEP IRAs, and Traditional IRAs. Placing funds in these accounts first is like kicking the can down the road
– the investor pushes out the day of reckoning with the IRS and state tax authorities, typically until retirement age. Until that time, money continues to grow tax free and take advantage of the great power of compounding. One is also likely to be in a lower tax bracket during the retirement years, so the tax bite will likely be less severe when the money is pulled out of these accounts.
3. Reduce Exposure to Professionally Managed Mutual Funds
– In addition to generally charging exorbitant fees and likely underperforming their passively managed counterparts, professionally managed mutual funds are generally tax inefficient
. For example, it is often difficult to control the capital gain and dividend distributions of these funds. It is even possible for such a fund to return a negative performance, yet still leave the investor with a large tax bill at the end of the year. Within an index mutual fund or broad market ETF, the investor can generally better control timing of capital gains/losses
. It is also easier to perform tax loss harvesting when investing in these passive vehicles compared to professionally managed mutual funds that contain multiple asset classes.
4. Shift Income-Generating Investments to Tax-Shielded Accounts
– Many investors have exposure to bonds or high-yielding stocks. Such instruments create current taxable income (no kicking the can down the road
). In the case of bonds, the interest is also taxed at the highest marginal tax rates. To the extent possible, it makes sense to place these investments in 401(k)s, IRAs, and other tax-shielded accounts, so that the tax bite doesn’t immediately hit. Another common tactic is to place investments under a child’s name, typically through a custodial account. The first $1,900 of investment income can be taxed at a lower effective rate compared to those of the child’s parents.
5. Continuously Harvest Tax Losses
– Tax loss harvesting is one of the most effective ways to reduce the tax bite on investments. Our article on the topic can be found here
. Most individuals wait until December to sell losers for tax loss harvesting purposes. In a volatile market, there are plenty of opportunities to switch out investments, maintain desired long-term exposures, and garner losses
that can be used to offset both capital gains and ordinary income ($3,000/year of ordinary income after all capital gains have been offset).
6. Place Foreign Investments in Taxable Accounts
– If an investor has international stocks – either individually or through a mutual fund or ETF – she is likely receiving dividends. A percentage of these dividends is generally withheld by non-U.S. governments (this is great way to raise revenue without upsetting the populace). It’s important to note that if the foreign investments are held in a tax-deferred account such as an IRA or 401(k), the investor does not receive a tax credit for taxes paid
. This is equivalent to giving the foreign government a nice holiday gift every year. It’s generally best to hold as much of one’s foreign holdings in taxable accounts as possible to receive any credits available come tax time.
7. Integrate Tax and Investment Advisors
– Many tax accountants serve the role of compliance professionals – they focus on accurately filling out forms and schedules and sending them in on time. Many investment advisors (or individual investors) focus exclusively on generating high returns without much regard to taxes. For the reasons we have discussed and many other ones, this is not the optimal way to invest. A unified, integrated view of taxes and investments is likely to achieve higher after-tax returns, which is the most important metric at the end of the day.
In short, even though the April deadline for filing is around the corner, there is still time to implement some of the aforementioned ideas. It’s a new year, and we hope that one of your resolutions is to be more tax efficient.
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