Key InSights:

• Too few investors have an active tax strategy
• The efficiency or a potential write off should not be the reason you own or sell an investment
• Managing federal and state income taxes is a year-long process
• Taxes are a permanent erosion of wealth
• Using the right investment and the appropriate accounts can help keep more of your money invested
• Certain strategies and accounts can support the causes you care about, transfer more money to your family, all while paying less in taxes
• Most tax strategies require little or no investment, and even the complex long term strategies can be developed and enshrined with little costs 

We work with clients and prospects who will happily spend untold hours researching stocks, bonds, and funds for the highest possible return on investment. They will bookmark and read articles about new funds, strategies, and investment opportunities. They watch investment shows, the news, and will ask friends for help and advice. In the past, we have addressed the importance of acknowledging the difference between accretive and erosive debt, and likewise, we think it’s important to discuss the difference between active and passive tax strategies. 

The vast majority of investors can be serviced better by addressing the most logical source of manageable loss in a portfolio: tax efficiency.

We love picking the right investments in a portfolio – but even the best funds and stocks outperform irregularly. However, a regular source of loss in a portfolio and one of the most avoidable is in the tax ecosystem investors build for themselves both inside and outside of a portfolio. This is the difference between a passive tax strategy and an active tax strategy. 

Investing with tax-efficiency in mind doesn’t have to be complicated but it does take some planning. While taxes should never be the primary driver of an investment strategy, tax awareness and some tax infrastructure does have the potential to improve after-tax returns for most investors. 

Passive Tax Strategy

Most investors and seemingly all of the do-it-yourself investors are part of the passive tax group. These are investors who will trade in and out of stocks of funds through the year, and come February and March of the following year, will likely need to write a check (or get their refund reduced) as a result of this methodology. Taking a year-end inventory of your investments and income will likely result in a double-digit taxation loss that might otherwise have been avoidable.

Additionally, several of the best and easiest ways to mitigate taxes can only be established before the taxable event has happened. Many of the passive tax strategies investors implement begin with managing a gain or loss when ideally they should begin months before so that all options can be weighed. Without knowing some of these tax-efficient strategies, investors have theoretically chosen to put blinders on and stick to their plan, or worse off, change it when it’s too late. Additionally, investors sometimes miss impactful tax law changes that tend to occur every couple of years. 

The harsh reality is that this method of tax planning over 30 years costs a person with a Bachelors’s Degree level of income about $226,000 in avoidable taxation over the course of their earning years. That sum mitigated differently and invested routinely can be worth over a million dollars in retirement or passed down to an heir or charity. For many that million-dollar difference is the difference between fully supporting their investment and legacy goals and being forced to sacrifice some part of their plan. 

There are several lever and investment manager can pull to try to manage federal and income taxes: selecting investment products, timing of buy and sell decisions, choosing accounts, taking advantage of realized losses, and specific strategies such as charitable giving can all be pulled together into a cohesive approach that can help you manage, defer, and reduce taxes.

Of course, investment decisions should be driven primarily by your goals, financial situation, timeline, and risk tolerance. But as part of that framework, factoring in federal and state income taxes may help you build wealth faster.

Active Tax Strategy

Investors have a variety of levers at their disposal they can use to transform their income and or investment tax strategy: selecting investment products, the timing of buys/sells, account types, tax harvesting, and specific strategies such as charitable giving can all be pulled together into a cohesive approach that can help you manage, defer, and reduce taxes. We have addressed many of those ideas below. 

But as I stated above, taxes shouldn’t be the driver for your investment decisions.  Those should be determined by your goals, financial situation, timeline, and risk tolerance. But as a complement to that framework, factoring in an active tax strategy for income and taxes may help you build wealth faster and in most cases, make you better prepared for life after work.

Tax budgeting: Part of a tax and financial plan involves knowing what the acceptable range for paying taxes is as part of the long-term equation. Generating income for the most part will result in taxation. But the difference between knowing a strategy for income and an investment that will generate a 38% tax liability or a 15% liability can save investors tens of thousands of dollars in a given year. 

Tax losses and loss carryforwards: Many investors are aware that a loss on the sale of security should be used to offset any realized investment gains. Fewer know that up to $3,000 in taxable losses can be used to offset ordinary income annually. In some cases, if your realized losses exceed the limits for deductions in the year they occur, the tax losses can be “carried forward” to offset future realized income. All gains and losses are “on paper” only until you sell the investment.

Tax-loss harvesting: This strategy involves taking advantage of losses as part of the rebalancing process. Deliberate capturing of losses can provide tax relief when investors have positions that have unrealized gains that they’re looking to sell. By “capturing” losses, or in other words, selling stocks and funds at losses and buying immediately back into something that isn’t substantially similar to avoid a “wash sale”, investors can stay invested, buy low and sell high, and have a bucket of losses to use to offset gains when they rebalance or adjust their portfolios. 

Capital gains and holding periods: Many investors are aware of the consequences of long and short terms capital gains. But for those who aren’t, securities held for more than 12 months before being sold are taxed as long-term capital gains or losses (LTCG or LTCL).  LTCGs taxes range today from 15-20% (additional 3.8% for high earners) versus 40.8% for short-term gains or ordinary income. Having a strategy around the holding period is a simple and cost-effective way to avoid paying higher tax rates and having one of the tentpoles for an active tax strategy. 

Fund distributions: Mutual funds are “pass-through” entities and as such, distribute earnings from interest, dividends, and capital gains every year. These distributions contain both long and short-term gains regardless of your holding period on the fund. Shareholders incur a tax liability on the date of record for the distribution in a taxable account. Therefore, mutual fund investors considering buying or selling a fund may want to consider the date of the distribution, the style of the fund, and their own budget for absorbing taxes.

Tax-exempt securities: The tax ramifications for different types of investments changes based on the underlying investments, and the vehicle type. For example, municipal bonds are typically exempt from federal taxes, and in some cases state tax. Real Estate Investment Trusts (REITs) and bond interest are taxed as ordinary income. So both the investment and the vehicle will be used to determine the tax liability. Additionally, the role of qualified and nonqualified dividends and their inclusion in a portfolio may determine the long-term performance of a portfolio. Qualified dividends are subject to the same tax rates as long-term capital gains, which are lower than rates for ordinary income.

Fund or ETF selection: Mutual funds and exchange-traded funds (ETFs) have very different structures and can routinely impact the long-term performance of a person’s portfolio. As we said earlier, mutual funds are “pass-through” entities and most ETFs are c-corps. So the rules they play by are different and impact investors differently. As a rule of thumb, passive funds tend to create fewer taxes than active funds. Additionally, the holding period for an ETF is determined by the investor and not the fund.

Trusts: Several tailored trusts can be written to materially affect the way an asset is owned and passed from one entity to another, and the cornerstone of an active tax strategy. They can delay and diffuse the payment of taxes, they can house and shelter individuals for the tax ramifications of a windfall or the passing of a loved one. Trusted are highly nuanced strategies that most investors avoid. They are long-term, often permanent, ways of mitigating and managing a tax liability and should be part of most investor’s tax strategy.