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Tax-Savvy Investment Management Has Never Been More Timely Thumbnail

Tax-Savvy Investment Management Has Never Been More Timely

By: Jim Picerno


Director of Analytics, The Milwaukee Company


It's not what you earn, it's what you keep that matters. The keeping part isn’t getting any easier, but fortunately there are numerous opportunities to squeeze more after-tax returns out of your investment strategy.    

It’d be nice if there was one easy, clean solution for maximizing after-tax returns with tax-aware investing strategies. Unfortunately, tax law is complicated and every investor’s portfolio and tax situation is unique. Meanwhile, markets are volatile and tax laws are forever changing. As a result, there are many ways to optimize tax-reduction strategies. 

That’s the bad news -- and the good news. Bad in the sense that you’ll probably have to cast a wide net to maximize tax alpha – the value added with tax-savvy investment management. This is also the good news because you can usually find several paths for keeping Uncle Sam’s tax bite to a minimum.

How much is tax alpha worth? A 2019 Envestnet | PMC study estimated the potential advantage at 1% a year. That, of course, can and will vary for a variety of reasons. But the implication is clear: there’s a real-world advantage here. 

Where to begin? A great place to start is by taking stock of what’s available – the tools of the trade, so to speak. Here’s a brief overview of the key opportunities available in the search for tax alpha. If possible, all the items listed below would be implemented. That’s not always possible or even necessary, depending on the investor and the portfolio strategy. Regardless, the following list offers a useful primer for thinking about the possibilities for keeping the tax bite to a minimum.

  • Tax-loss harvesting: This is a trading technique for an investment portfolio that offsets a gain with a loss without materially altering the asset allocation. 

A simple example: You own ABC Stock Fund and it’s currently posting a 20% loss. You sell the fund, book the loss and immediately buy a similar fund, thereby maintaining the same exposure to the asset class while generating a tax loss that can be used to reduce a taxable profit generated elsewhere in the portfolio. 

It’s important not to run afoul of the IRS wash-sale rule, which occurs if a “substantially” identical security is purchased within 30 days before or after the sale. How does the IRS define “substantially”? Unfortunately, the answer’s a bit of a grey area, perhaps by design – until or if the government decides to clarify. But as a practical matter, it’s generally accepted that swapping, say, ExxonMobil for Chevron is okay. Similarly, most investment advisers and accountants are comfortable with selling the SPDR S&P 500 (SPY) and buying iShares Russell 1000 ETF (IWB), roughly equivalent large-cap U.S. equity funds that track different indexes.

  • Tax-lot management: Another technique linked to securities transactions is favoring the securities lots that were purchased later to reduce the taxable profit. 

For instance, let’s say you bought 100 shares of XYZ stock at $50 on March 1 and another 100 shares on June 1. Assume that the stock rose in price between March 1 and June. If the stock continued rising and you decided to sell 100 shares on December 1, selecting the June 1 lot to sell would result in a lower capital gain compared with selling the March 1 lot. The key point is to specifically identify the lot to sell to minimize the tax bite.

  • Extend capital gains over different years: This is a twist on tax-lot management by spreading gains out over several years. Specifically, sell a portion of an investment with an embedded capital gain in one year and the remainder in the following year. This would result in spreading (deferring) the taxable consequences over two years rather than concentrating it in one year. The risk, of course, is that the price could fall between the first- and second-lot sale. If the price falls far enough, the decline will wipe out any benefit of deferring the tax. 

There is one exception to the foregoing suggestion, and that applies when tax rates are expected to go higher. In that case you may want to trigger all of the gain in year one, before taxes have a chance to move higher.

  • Favor exchange traded funds (ETFs) over mutual funds: All else equal, you’re better off in an ETF from a tax perspective. Product design is the reason. 

In contrast with open-end mutual funds, ETFs have a unique procedure for buying and selling securities – an “in-kind” methodology that allows redemptions and sales without selling the securities and realizing capital gains. Open-end funds don’t have that capability, which means that mutual funds tend to generate substantially greater taxable distributions. If you also favor indexing in your choice of ETFs (vs. actively managed ETFs), the potential tax efficiency is even greater since index funds generally have lower trading activity (and thereby lower taxable events) vs. actively run strategies.

  • Asset location: Where you hold securities and funds matters for taxes. As a result, thinking strategically about which of your accounts will reduce taxable events is another tool to raise tax alpha. The general rule is to strive to hold the least-tax efficient securities (bonds and high-distribution investments such as real estate investment trusts) in the most tax-efficient accounts (IRA, 401(k), etc.).

For example, let’s say you have a taxable bond ETF that could be purchased in a standard brokerage account or in an IRA retirement account. If you choose the latter, the taxable distributions from the fund will be deferred until you reach 72 years of age (70 ½ if you reach 70 ½ before January 1, 2020). The same fund held in a standard brokerage account, by contrast, will trigger taxable distributions every year. The general rule is to strive to hold the least-tax efficient securities (bonds and high-distribution investments such as real estate investment trusts) in the most tax-efficient accounts (IRA, 401(k), etc.).

  • Account-redemption management: This technique is similar to tax-lot management (as outlined above) except that it applies to carefully selecting accounts for liquidating securities. Depending on how your assets are distributed across accounts, this may or may not be feasible. But ideally, you’d sell securities in taxable accounts first and leave other investments intact in tax-friendly IRA and ROTH accounts, for example. 
  • Favor long-term over short-term investment horizons: Although it’s not always possible, depending on the investment strategy and the investor, you should always be looking for opportunities to hold securities for at least one year to avoid the higher tax rates associated with holding periods of less than one year.
  • Rebalancing with distributions: When it’s time to rebalance your portfolio, look for opportunities to use dividends, income and other distributions to finance transactions. If, for instance, your rebalancing event requires raising the equity allocation to 65% from 60%, try to facilitate the transaction with distribution flows from elsewhere in the portfolio. The greater you’re able to do so will reduce the need to sell other securities that could potentially trigger tax consequences.
  • Charitable giving: If you’re inclined to be philanthropic, the effort can be a win-win effort. In addition to helping a cause or s community, there are tax-related benefits. This is a huge area for planning choices and so consulting with one of O’Leary-Guth Law Firm’s tax advisors is recommended. But as a general rule, charitable giving is another arrow in the tax-alpha quiver. 

    Strategies designed to maximize the tax advantages of giving include donating highly appreciated securities and consolidating charitable gifting to years when your taxable income is relatively elevated.

    • Securities-based lending: Instead of selling securities and realizing capital gains, you could take out a loan via a brokerage account and use the securities as collateral. In this case, you’d avoid a capital gain while monetizing a portion of the asset holding. The downside is that you’ll be asked to replenish the account with cash or other assets if the securities used as loan collateral fall in value.