By: Jeff Deloglos, Trust Officer, ESSA Bank & Trust
When evaluating the performance of your investment portfolio, a typical focus might be to examine strategy, time horizon, and the asset allocation of risk. A typical “top of mind” question one might ask may be whether your portfolio has outperformed or underperformed established market benchmarks? Another may be are any risk/return adjustments necessary at this time? A broader query and most certainly a prudent question you may also ask is: What is the probable tax impact of my current investment strategy? Without a careful tax efficient focus, your work (or that of your advisor) remains incomplete. After all, taxes can have an impact on how your wealth compounds over time.
Tax efficient portfolio management is an attempt to minimize tax liability when making strategy decisions whose success is measured by how much of a return remains after taxes.
Taxable vs. Tax Advantaged Portfolios
There are two types of portfolios affected by taxation. A taxable portfolio takes a “current-tax” approach where as a tax-advantaged portfolio assesses the retirement distribution impact. As a general rule, one may wish to consider holding tax efficient investments in taxable accounts and less tax efficient in tax advantaged accounts.
A taxable account may use a “buy and hold” strategy incorporating stock, bonds, and/or tax efficient mutual funds or ETFs to reduce the tax cost. Limiting portfolio turnover and managing the type of income produced impacts tax levels assessed.
Tax Advantaged accounts such as IRAs, 401(k)’s/ 403(b)’s and deferred-compensation plans take into consideration the accumulation phase of the financial lifecycle allowing deferred taxation. Allocating investments most likely to generate investment income and gains should be considered. And one would also anticipate (hope) that taxes will be lower at payout when retirement occurs.
Designing a Tax Efficient Portfolio
While supporting broad diversification, the portfolio design process should include avoiding taxable activities. Income and capital gains distributions account for most taxable events. When creating your tax strategy seek out qualified dividend income rather than non-qualified dividend income. Hold assets more than a year to avoid the highest capital gains tax rates. Include tax-loss harvesting to offset gains with losses in taxable accounts. Other options include using low turnover mutual funds, investing new dollars to balance a portfolio by adding to underweighted asset classes as an option to selling positions. Use gifting for appreciated assets.
Tax Free or Tax Efficient Choices
The choices for the least possible taxation may include municipal debt, which is generally free from both federal and state taxes but may be subject to AMT. Although yields on municipal debt may be lower than a comparable high-grade corporate bond. Tax-Efficient Mutual Funds and ETFs are designed to avoid frequent turnover and the generation of realized capital gains.
Managing Tax Efficient Portfolios
Investment styles may drive tax triggers. Three prominent investment styles prevail: Active Management, Passive Management, and Factor Management. Active Management attempts to predict market trends often by speculation, in order to capture returns. This style uses statistical measurements and an analytical process to determine what to buy, sell or hold. Tax efficiency is not a focus.
The opposite of active management is Passive Management (also referred to as “indexing”). This style tracks a market-weighted index or portfolio such as the S&P 500 by mimicking the performance. The goal is to obtain diversification, low turnover, and low management fees. However, when an Index such as the S & P 500 announces a change, the index fund manager must also change the holdings of the Index fund. As a result, the inflexibility dictated by this style may create adverse tax consequences.
Factor Management combines the flexibility of an active style with the discipline of an index. It utilizes factors that target higher expected returns in a cost-effective manner. Based on efficient markets, human judgement is used to enhance decisions around market capitalization, relative asset value and above average profitability.
Choosing the best tax-efficient investment can be a daunting task for those with little knowledge of the different types of products available. Yet prudence suggests that you have a fundamental understanding of the long-term impact your investment tax strategy could have on your wealth. Therefore the best decision may be to contact a financial professional to optimize your tax strategy.