Minimizing taxes from investment activities is important because it’s one of the few aspects of investing that an investor can gain significant control over. Paying attention to the tax consequences of investing can substantially increase long-term wealth and increase spendable income.
- Stocks are taxed on dividends and realized capital gains only, whereas if the same stock or equity fund is held in an IRA, upon distribution, the total return is fully taxable at the investors highest marginal rate.
- The tax rates applied to dividends and capital gains are lower than the ordinary income tax rate associated with withdrawals from tax-deferred accounts.
- Upon death, there is a step up in basis on stocks, eliminating the capital gain liability, although not for 2010. This is not available if stocks are owned in tax-deferred accounts.
- There can be opportunities, in taxable accounts, to use tax loss harvesting to further reduce capital gains tax liability. This isn't available in tax-deferred accounts.
- High cost accounting in taxable accounts: If multiple tax lots of the same security have been acquired over time, upon sale, specific “tax lots” can be selected to minimize tax.
- Minimizing required IRA distributions: If bonds produce lower returns versus stocks (expected), then the required distributions from IRAs during retirement will be less.
Tax Loss Harvesting
Mutual Funds versus Separately Managed Accounts
Mutual Fund Tax-Sensitive Accounting
Another sophisticated accounting method for minimizing tax is an “in-kind redemption.” When a single shareholder makes a large redemption request, a mutual fund has the discretion to deliver a basket of the underlying equity securities owned by the fund instead of cash. The capital gains associated with the basket of securities are distributed to the redeeming mutual fund shareholders and the mutual fund will pick the lowest tax cost for the underlying securities to maximize the benefit of the in-kind redemption. Exchange traded funds commonly use this method of in-kind redemptions to flush out potential realized gains.
Tax-Managed Index Funds
Within a TMAC, realized taxable gain from stock turnover will be negligible due to low turnover, matching losses with gains, an “expanded trading range.” The “expanded trading range” is a set of trading rules that the fund manager will place on stocks before selling. For example, a small company grows too big to be considered small (for a small company index fund). A TMAC will allow a wider range of price change before selling, thereby postponing or even eliminating a taxable capital gain. Reducing taxable dividends is desirable as long as the portfolio’s expected return remains the same. All other things being equal, if two portfolios have the same expected return, the one with a lower dividend will produce a higher after-tax return, with a relatively higher portion of the return coming from deferred capital gain.
Dividend management is accomplished in several ways: For example, portfolios are constructed by reducing the percentage of high dividend-paying stocks and increasing low dividend-paying stocks—without sacrificing the financial characteristics of company size or price/book and without changing the expected return of the portfolio. Another technique to minimize dividend income is to postpone the purchase of new securities just prior to the record date of the dividend (for stocks intended to be purchased) or accelerate the sale of a stock just prior to the record date (for stocks that are intended to be sold). This way the total return is not altered, but the taxable dividend has been avoided.
Tax loss harvesting is a technique to further minimize tax. A stock with a loss is sold and replaced with a stock of similar market cap and price/book. The objective with tax loss harvesting is to reduce capital gain liability without changing the financial characteristics of the portfolio. Passive tax-managed funds are currently available for the following asset classes and are utilized by, Summit Portfolio Management:
- US Core Equity (value and small companies tilt)
- US Large Cap Value
- US Small Cap Value
- International Core Equity (value and small companies tilt)
- International Large Cap Value
- Emerging Markets Core (value and small companies tilt)
Astute asset class placement between accounts, utilizing tax loss harvesting, tax sensitive accounting and employing tax-managed asset class funds can provide the optimal benefits of tax-efficiency with maximum effective diversification. A recent study by Vanguard showed that an astute advisor employing tax management techniques can add .75% or more annually to an investor’s after tax return. The rigorous application of these powerful tax-minimization techniques can help an investor retain more of their hard-earned wealth and be able to have more spendable income.