While there is wisdom in the maxim, “Don’t let the tax tail wag the investment dog,” it is also the case that a focus on tax efficiency can be of significant benefit to portfolio performance, especially for high-net-worth clients. In certain cases, foregrounding tax-management strategies, including recognition of losses when appropriate, can have a meaningful positive benefit on overall investment performance. In this article, we will target some specific strategies that can contribute to greater tax efficiency, thus allowing the investor to retain more of the earnings.
Targeting Long-Term Capital Gains
Emphasis on generating long-term investment gains, which receive a more favorable tax treatment than short-term gains or ordinary income, is one avenue that deserves focused attention.
Most investors know that for short-term investments (held for one year or less), gains on the sale are taxed at the same rate as the investor’s marginal income tax rate. By contrast, the tax liability generated by a long-term capital gain (for an investment held a year or more) can be significantly lower.
For example, consider a married couple with a combined annual income of $752,000. They would fall into approximately a 37% marginal income tax bracket, under today’s tax rules. However, at their current level of income, they would pay taxes on long-term capital gains at only a 20% tax rate. As a result, the couple can potentially earn an implied 17% additional return on their investment gains simply by holding an appreciated asset for at least one year in order to qualify for the long-term capital gains rate.
Tax-Loss Harvesting
In the ordinary course of events, most portfolios will require occasional rebalancing in order to stay within the established asset allocation guidelines. When this occurs, it is often necessary to sell some investments that have gained in value, thus generating short- or long-term capital gains. However, by judiciously recognizing losses in other assets, the capital gains burden can be ameliorated, to an extent.
By selling an asset that has fallen in value since purchase, the investor may be able to generate an investment loss that can be used to offset some or all of the gains generated in other parts of the portfolio. The IRS requires that short-term gains should be offset by short-term losses, and similarly, that long-term gains should be offset by long-term losses. However, if losses of either type exceed gains of the same type, the excess losses can be used to offset gains of the other type. Further, if losses exceed all gains, up to $3,000 of losses may be used to offset ordinary income. Unused losses (in excess of gains and the $3,000 offset to ordinary income) from a given year may be carried forward and applied to gains incurred in a subsequent year.
A final note on tax-loss harvesting: When using this strategy, care must be taken to avoid violating the “wash sale” rule, which prohibits purchasing an asset identical to or substantially similar to the asset sold at a loss for a period of 30 days before or after the sale that generated the loss. If this rule is violated, the loss is disallowed and may not be used to offset gains.
Emphasizing Long-Term Holdings
As suggested above in the discussion of capital gains, investors who are interested in tax efficiency may be well advised to focus on holdings that do not feature frequent trading, as is the case with certain actively managed mutual funds, for example. Assets that are subject to frequent purchases and sales will typically generate more short-term capital gains, which receive less favorable tax treatment than long-term gains. On the other hand, funds and ETFs that are less subject to frequent trading—such as index funds, for example—may be less likely to generate short-term gains and, thus, more likely to produce more tax-efficient returns.
Consider Tax-Exempt Income
For investors in higher marginal brackets, tax-exempt income—typically generated by the tax-free interest from municipal bonds—can offer attractive yields when the tax-exempt character of the income is taken into account.
For example, consider a AAA-rated municipal bond issued by an entity in the investor’s home state. The interest paid by such a bond would be exempt from both federal and state income taxes. If the investor were in the highest current marginal bracket of 37%, a bond paying 3% interest would generate a tax-equivalent yield to the investor of 4.76%. In other words, the investor would need to own a taxable bond paying 4.76% interest in order to achieve the same after-tax income generated by the tax-exempt bond paying 3%.
Leveraging the Charitable Impulse
Investors’ philanthropic and charitable aims can also be incorporated into the tax-efficient investment approach. Though recent tax laws have limited the deductibility of certain types of charitable giving, donor-advised funds (DAFs) have maintained popularity for their ability to accept various types of assets—generating an immediate charitable deduction for the donor—and then distributing the assets, sometimes over a period of years, according to the direction of the donor. This permits donors to bundle several years’ worth of charitable gifts into a single year, potentially generating a charitable deduction sufficient to offset a larger amount of income. DAFs also offer the opportunity for donors to gift appreciated assets, thus avoiding the tax liability that would otherwise attend their sale.
A Unified Approach
There are additional tax-efficient strategies that may be applied to help investors retain a greater portion of their portfolio gains. Ultimately, consultation with a fiduciary financial planner who is familiar with the investor’s overall resources, goals, priorities, and values can offer significant advantages. By structuring accounts and building portfolios that take into account the investor’s tax concerns, the financial advisor may be able to help the investor achieve favorable long-term returns, even after taxes are taken into account.
If you have questions about the tax efficiency of your portfolio, please reach out to a Rothschild advisor today!
Disclosure: The information presented is not a comprehensive analysis of the topics discussed, is general in nature, is not personalized investment advice and should not be construed as a recommendation to purchase or sell any particular security or strategy. This material is for informational purposes only and is not intended to provide investment, legal, tax recommendations or advice.
