It's Not How Much You Earn, It's How Much You Keep: The Value of Tax-Efficient Investing

Jeffrey C. Coburn, CFA, Managing Director and Portfolio Manager, First Republic Investment Management

November 4, 2015

All investors have unique goals, but one thing most have in common is the need to have a tax-efficient strategy, which can be a critical component in helping reach one’s financial objectives. 

While having a long-term, low turnover approach goes a long way to being tax-efficient, there are a number of things investors can do regarding their portfolio structure and active portfolio management to improve after-tax returns.  For example, crafting and maintaining a tax-optimal portfolio structure can be accomplished with detailed financial planning.  Part of the planning exercise should be to make sure you have the liquidity necessary at different stages of your investing horizon.  Often times the end result is an investor will want/need to have a taxable bucket and a tax-deferred bucket (e.g. retirement accounts).  In most cases, maximizing the amount you contribute to investment accounts with solid tax advantages is a sound strategy.  Some examples include:

  • Individual Retirement Accounts (IRAs)
  • Roth IRAs
  • 401k and 403b plans
  • 529 college savings plans

From there, investors should focus on asset location.  Asset location is the process of identifying which investments are best suited for taxable accounts and which are best suited for tax-deferred accounts. For instance, more tax-efficient investments such as municipal bonds, individual stocks and exchange-traded funds (ETFs) could be located in fully taxed accounts. By contrast, many investments that generate high level of ordinary income or many actively traded mutual funds with high turnover or large embedded gains may be better suited for tax-advantaged accounts. In some instances this may not be feasible or practical but asset location should be at least considered during the portfolio construction process.

Estate planning and gifting programs are additional elements of tax-effective investing and money management. By working closely with their financial and legal advisors, investors can leverage a variety of creative options, including:

  • Irrevocable gifting trusts- Reducing the taxable estate and or bypassing generations can be useful in avoiding estate taxes.
  • Annual gift tax-exemption—Effective for proactive distribution of an estate, investors can make an unlimited number of $14,000 gifts of cash or other property annually, completely tax-free.
  • Philanthropic options—Setting up a donor advised fund, charitable trust or private foundation can provide current tax advantages as well as be useful in avoiding estate taxes.

After the correct structure is in place and the investments have been optimally allocated, active portfolio management can then add value. For example, investors have the opportunity to “harvest” losses by selling investments that have declined in value and either reinvesting in a similar but not identical investment or holding in cash and buying back the same investment in 31 days.  Doing this allows investors to either offset other capital gains, or reduce taxable income up to $3,000 per year. Investors should also pay close attention to mutual fund distributions and if it makes economic sense, trade away from funds temporarily that have declared large capital gain distributions. As valuable as tax-related guidance is to any investor, it’s essential to keep primary financial goals in perspective. Although tax impact is important, investment decisions still need to be based on financial merit and potential.

Like any strategy, it takes close coordination between the investment professionals (portfolio manager, accountant and estate attorney) as there are a number of pitfalls that can occur when trying to implement the aforementioned strategies such as the wash sale rule, and unrelated business tax income limit.  Changes in individual circumstances can also have a significant impact on both the financial plan as well as tax exposure and should be communicated in a timely manner. 

Lastly, a philosophy that is grounded in producing after-tax results is valuable to a wide variety of investors, regardless of financial means. No matter the size of the portfolio or the relevant tax bracket, the same rule of thumb applies: it’s not how much you earn, it’s how much you keep.

This article is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein.

All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client's expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results.

Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.

The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that First Republic (or FRIM) does not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document.

©First Republic Investment Management, 2015