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)
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 — the Internal Revenue Code allows individuals to gift up to $15,000 each (in 2020) to an unlimited number of recipients per calendar year. This “annual gift exclusion” amount is indexed to inflation (subject to $1,000 increments). Therefore, investors can gift cash or other assets, up to the annual gift exclusion amount, to as many people as they wish every year, completely tax-free. This is effective for proactive distribution of an estate.
Philanthropic options —Setting up a donor advised fund, charitable trust or private foundation can provide current tax advantages as well as being useful in minimizing 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). 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.