By: Frank Armstrong
By: Frank Armstrong, III, CFP, AIFA®
Taxes are the biggest expense investors face, so it follows that comprehensive and effective tax management will have a major impact on real long term returns and accumulations. A dollar that flies off to the IRS disappears into a black hole and isn’t coming back. A tax deferred or avoided keeps those dollars at work for you to build future wealth. But, keep in mind that tax minimization is not the objective of a rational tax policy, its maximizing after tax return.
Our investment strategy utilizes only index funds and ETFs, but you can certainly apply the same principles to individual securities.
1. Index Funds
Every time a mutual fund or managed account buys and sells a position it generates a taxable event. At the end of the year the sum of these events gets reported to the IRS, and the owner gets to pay taxes on the income. The higher the turnover in the portfolio, the higher the tax bill. Sometimes to the owners very great dismay the fund distributes large taxable gains while experiencing very real losses. I personally hate when that happens, so one of the very many good reasons to use index funds or passive ETFs is that they are very tax efficient because they so seldom turn over their positions. Even if they didnt outperform or carry lower risk than managed funds (which they generally do) you would want to hold them as your default choice for investing in the worlds markets.
2. Tax Managed Index Funds
Index funds were first adopted by savvy institutions like pension funds that had no tax exposure. As they became more widely accepted by taxable investors they realized an opportunity existed to further improve on their tax efficiency by slightly modifying their policies. Tax managed mutual funds internally hold positions until they qualify for long term gains, exercise tax loss harvesting, and utilize HIFO (highest in “ first out) accounting on their lot sales. These techniques are described below in greater detail.
3. Tax loss harvesting
Its highly unusual to have a period when all your holdings go up. But, if you have losers in the portfolio, you can turn some of those lemons into lemonade. By selling a loser you recognize a loss for tax purposes. You can use that loss to reduce gains. And even if you dont have gains to pair them against, you can carry forward those losses indefinitely until you do. Its like having a piggybank to pay your future tax obligations. Normally we would buy a similar but not identical fund to remain exposed to the asset class, hold it until we satisfy the waiting requirement of the wash rule (31 days) and then switch back. You dont necessarily want to wait until the end of the year. The time to harvest losses is when you have them, so the portfolio should be continuously monitored for opportunities as they occur.
4. Dividend avoidance
If you hold a fund that will shortly pay a dividend, you may wish to avoid it. Compare the tax cost of selling the fund if there is a potential gain with the tax cost recognizing the dividend if you hold it. If it triggers less cost (both short and long term) to sell the fund than to pay the tax on the dividend, sell it. Of course, if you should recognize a loss on the sale you will have to comply with the wash sale rules as described above. Fund companies and ETFs routinely announce the date and estimated dividend to be paid, so you can plan a strategy to minimize the implications.
5. Hold for long term gain
If for any reason you wish to pare a position that contains a gain, you may wish to wait until the gain qualifies as long term rather than short term to take advantage of the substantially lower capital gains rates.
6. Tax Lot identification
Identifying lots rather than using average cost can result in significant savings whenever portions of a position are sold. Lets say you had 1000 shares of Vanguards S&P 500 fund that you had accumulated over the years with multiple purchases and dividend reinvestment. All those purchases had a different cost per share. Now when you want to sell some, you can identify and sell specific lots with the highest cost which will minimize the capital gains taxes due on the sale.
7. Asset Location
Most of our clients have a mixture of fully taxable personal accounts and tax deferred or tax free account such as 401(k)s, IRAs, or Roth IRAs. Even tax efficient index funds generate some taxable events during the course of the year, and some have a lot more taxable distributions than others. For instance, REIT funds pay high levels of fully taxable dividends, and small company funds generate portfolio turnover when companies grow out of the funds hold range. So, placing those funds inside tax preferred accounts where available will minimize your total tax bill.
8. Municipal Bonds
Far more people buy municipal bonds than they should in an attempt to avoid taxes on their fixed income investments. Unless you are in the highest federal and state tax brackets, it usually wont pay off because normally municipal bonds carry lower returns than a similar risk and duration taxable bond might. So, lower bracket investors can end up with a lower after tax return, higher risk, higher cost, and lower liquidity than if they just purchased a taxable portfolio. However, if you are in the highest income tax brackets you can benefit. Its a simple process to determine if the Municipal Bond Tax Equivalent Yield is beneficial. Our calculator makes it a snap