December is a wonderful time to reflect on accomplishments and set goals for 2019. In conversations with clients, we have found that taxes begin to pop up on the radar this time of year, as well. Much preparation may go into tax season, and an early start is usually smart. With that in mind, you may want to consider how you’re currently positioned with your portfolio from a tax perspective and the benefits you might gain from a “tax-aware” investment strategy.
What it's all about
The end goal of a tax-aware approach is to maximize your after-tax return. It’s a philosophy designed to actively prioritize capital gains over taxable interest income and postpone the realization of taxable gains, especially short-term gains, while maximizing realized losses and minimizing transaction costs.
While those in the highest tax brackets may reap the biggest rewards, all investors who are tax-sensitive may be able to leverage a tax-aware strategy to enhance their after-tax return.
It’s important to note that a tax-aware approach complements but does not take the place of benefits you can gain from a well-diversified strategy. We believe tax awareness must be undertaken without adversely affecting the proper asset allocation. Otherwise, you may reduce overall returns and put longer-term goals at risk.
The nuts and bolts
The objective of a tax-aware approach is to utilize a mix of active and passive strategies via individual securities, mutual funds (both index and actively managed funds) and exchange-traded funds, with the goal of lifting after-tax returns. Low turnover (little or no capital gains distributions) in a mutual fund or portfolio is a fundamental component of a tax-efficient strategy, as it reduces any taxable distributions which are required to be paid out each year.
Another consideration is the type of fund you might purchase. In a globally diversified equity portfolio, a tax-aware approach favors domestic large- and mid-cap markets because portfolio turnover is relatively lower. Products that index to the S&P 500 or track broad-based large cap indexes are typically ideal.
Small-cap funds and those who seek profitable opportunities in emerging market stocks generally have a higher turnover. They enhance diversification and may produce higher risk-adjusted returns over the long term, but they are not tax efficient.
Taxable versus tax-deferred
How you distribute assets across taxable and tax-deferred accounts, such as IRAs, is an important consideration in maximizing tax efficiency. Taxable accounts, for example, would likely be the appropriate place to hold ETFs and index funds with very low turnover.
On the other hand,
Morningstar points out, “The average tax-cost ratio for equity funds tends to fall between 1% and 1.2%.” If these funds reside in a tax-deferred account, distributions are sheltered. Likewise, in a tax-aware strategy, tax-deferred accounts might be the appropriate place to hold actively managed mutual funds, small-cap funds and emerging market funds that naturally have higher turnover and, therefore, higher distributions. The same holds true of taxable bond funds and funds that seek out high-dividend securities.
| Taxable Accounts |
Tax-Deferred Accounts |
|
Tax efficiency, low turnover, passive investing
Include:
- ETFs, Index funds
- Domestic large- and mid-cap funds
- Muni bonds funds for high-income taxpayers
- Securities that pay no or low dividends
|
Shelters lower tax efficiency, higher turnover, active management
Include:
- Actively managed funds
- Small-cap and emerging market funds
- Taxable bond funds
- Securities that pay higher dividends
|
If you hold a mix of college savings vehicles — with some exposed to taxes (such as a UGMA account) and others not subject to taxes — you might employ a similar approach as described above as part of a tax-aware strategy. If you’re in a higher tax bracket, then tax-free municipal bonds may be an excellent tax-aware fixed income strategy. And if you’re subject to the 3.8% Medicare surtax, you may find it beneficial to hold higher-dividend-paying stocks in an IRA, escaping the surtax.
Gains, losses and deadlines
This year’s market volatility may make it more advantageous to recognize any capital losses and gains. For example, you may decide to sell ABC stock held less than one year, recognizing a $15,000 gain, and sell XYZ stock, generating a short-term loss of $14,000. By pairing the sales, ordinary income rises by just $1,000.
Another avenue is to harvest losses held less than one year and gains held for more than one year. Using a highest-in, first-out (HIFO) method when selling stock can help ensure you identify shares purchased at the highest price, reducing taxable capital gains.
Be sure not to run afoul of the “wash-sale rule,” which would disallow the loss. A wash sale occurs when a security is sold at a loss and the investor buys a “substantially identical” security 30 days prior to or after the sale. Also, when rebalancing, it’s important to earmark proceeds into the correct asset allocation.
Remember that transactions for tax year 2018 must occur by December 31.
Final thoughts
Implementing a tax-aware strategy can be part of your annual portfolio review and adjustment routine — a habit that could help further boost your returns. In fact, a 2014 study by Vanguard suggests investors could add up to 3% to their annual portfolio return by reducing costs, rebalancing, behavioral coaching and the proper allocation of investments between taxable and deferred-tax accounts.
If you’d like to learn more about how a tax-aware strategy might fit into your portfolio, or if you want broader guidance as you evaluate your portfolio and refresh your financial plan for the new year, our experts are here to help. Please feel free to reach out to us and schedule a personal consultation.
The information, views, opinions, and positions expressed by the author(s), presenter(s) and/or presented in the article are those of the author or individual who made the statement and do not necessarily reflect the policies, views, opinions, and positions of Hancock Whitney Bank. Hancock Whitney Bank makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information presented. This information is general in nature and is provided for educational purposes only. Information provided and statements made should not be relied on or interpreted as accounting, financial planning, investment, legal, or tax advice. Hancock Whitney Bank encourages you to consult a professional for advice applicable to your specific situation.
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