Tax-Efficient Investing: Don’t Lose Portfolio Gains to Taxes

The Beatles taught me my first lessons about taxes when I heard the song “Taxman” as a teenager. Years later, George Harrison’s lyrics about taxes frame a lot of my client conversations, as George was not joking when he wrote, “Let me tell you how it will be: there’s one for you, nineteen for me, cause I’m the taxman.” This line may ring true to high income earners, many of whom find themselves in a marginal bracket that is close to fifty percent when you factor in federal, state, and local taxes. Just as taxes take a bite out of your income, they can also take a bite out of your investment portfolio. Taxes can exact significant drawdowns on your savings, impacting your ability to grow your wealth and meet your long-term savings goals. Fortunately, there are some strategies investors can use to maximize the tax efficiency of their investments and minimize the tax impact on portfolio growth.

Asset location

Everyone knows about asset allocation, but asset location is also critical. Most investors have some combination of taxable accounts, tax deferred accounts, and tax-free accounts. Tax-advantaged retirement plans such as 401(k)s and IRAs, for example, are tax-deferred, and growth is tax-free in Roth accounts. These types of tax-advantaged accounts, however, have limits to how much you can contribute and rules about when you can withdraw your savings. Regular brokerage accounts have much more flexibility, but are taxable, with investment dividends and gains subject to income tax or capital gains tax.

Being strategic about distributing your assets in different investment vehicles across different accounts can make a big difference when it comes to taxes. Because more aggressive investments will likely grow faster and enjoy greater earnings, they may be better candidates to include in tax-free Roth accounts when possible. Along similar lines, investments that make regular income payments may be better suited for tax-deferred IRA accounts in order to keep the income from being taxable until the IRA owner takes a distribution.  Taxable accounts may be best suited for highly tax-efficient investments like direct indexes (see below) or other tax-managed strategies.

Tax-efficient investment vehicles

There are several types of highly tax-efficient investment vehicles that can play a role in mitigating the tax impact on a portfolio. It may be worth considering incorporating these types of vehicles in your taxable accounts.

Municipal bonds

The interest on municipal bonds is free of federal taxes, and sometimes tax-exempt at the state level as well. Municipal bonds may be a great addition to the bond allocation of your taxable portfolio, particularly if you are in a higher tax bracket. Your Coldstream wealth manager can share information with you on the tax-equivalent yields of municipal bonds in your state to help with this analysis.

Tax-managed funds and ETFs

Some mutual funds and ETFs are managed specifically with an eye toward reducing the tax burden on the portfolio. They may trade less frequently, use tax-efficient assets, and employ strategies such as tax loss harvesting.

Direct indexing

Direct indexing is a process whereby an investor builds a portfolio designed to replicate the performance of a select index (much like popular index mutual funds and ETFs), but does so by purchas­ing individual shares of the underlying companies rather than buying a share in a fund. Those individual positions are then managed as a separately managed account with individual control over each holding.

Because investors in a direct index have their own basis in each underlying position, they collect dividends and income from each as they are distributed and only recognize capital gains when they elect to sell. Furthermore, because direct indexing allows investors to own the underlying securities, an investor can make adjustments to his or her portfolio to minimize capital gains tax in ways that mutual funds cannot; for example, by gifting a specific appreciated security to charity or by deciding to hold onto a stock until the investor moves to a lower tax state or into a lower capital gains bracket.

Furthermore, algorithmic trading has made direct indexes highly adept at capturing short-term tax losses, examining each holding throughout every trading day in an effort to seek and book tax losses when appropriate. This is called tax loss harvesting, as these losses can be used to offset gains elsewhere.

Tax loss harvesting

Whether or not you incorporate direct indexing into your portfolio, you can make use of the strategy of tax loss harvesting, selling positions that have dropped in value in order to realize the loss for tax purposes, offsetting capital gains elsewhere. Investors are allowed to carry losses forward to offset taxable gains in future years, which can have a meaningful impact on the after-tax growth of a portfolio.

Conclusion

Strategies for tax efficiency are an important aspect of your overall wealth planning. The more you can compound your earnings without the bite of taxes, the more your wealth is able to accumulate over time. Work with your Coldstream advisor to identify the strategies and approach that will work best for your situation.

*All of Coldstream’s staff shall attain the required licenses and designations necessary for his/her position. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP® and Certified Financial Planner™ in the U.S.

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