In most client situations, stocks should be held to the extent possible in taxable accounts. Conversely, bonds should be held in tax deferred accounts. This is due to several reasons:

• 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.

Even among index funds, some are more tax-efficient than others. If an asset allocation involves placing a portion of the equity allocation in a tax-deferred account, the least tax-efficient funds should be placed there first; For example, REITS, or an international small value fund (for which there are no tax-managed funds), are better served in an IRA than in a taxable account.

Just as a fund manager can take a realized loss and match it with a realized gain with stocks in a mutual fund, a portfolio manager can do the same with portfolio funds. Generally, a paper loss of 10% or more would be sufficient to sell a fund, realize the loss, and replace it with another fund. The objective of the transaction is a reduction in current or future tax liability.

Is it better to make equity investments using mutual funds or separately managed accounts? Each investment structure has advantages and disadvantages. To provide a potential tax advantage using individual stocks, a portfolio would have to be in excess of $50 million.

Investors normally do not associate tax-sensitive accounting with mutual funds. A big benefit to mutual funds comes from positive cash flows into the fund. With additional cash flows a mutual fund can have many different tax lots for a given stock. Disposals can therefore be handled in a more tax-efficient manner; realized gains are minimized by using high cost basis when selling a particular company’s stock. Several other accounting methods unique to mutual funds can minimize the tax impact of large cash redemption's. If a mutual fund has large redemptions during the year, it can assign the realized capital gains resulting from the cash redemption via an accounting method called “dividend equalization.” Dividend equalization assigns a portion of realized capital gains to the cash redemption, thus reducing the capital gains distributed at the end of the year to remaining shareholders.

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.

There are several accounting methods that the IRS allows for securities transactions. The method that usually keeps the tax bite the lowest is known as “high cost” accounting. High cost accounting selects the highest cost tax lots in a sale thereby incurring a lower tax impact.

The tax-free income from municipal bonds can provide higher after-tax returns compared to corporate or treasury bonds for investors in higher tax brackets. For investors in the federal marginal tax bracket of 28% or higher, municipal bonds may provide a higher after-tax return. However, investors need to be aware of the unique risks associated with municipals; liquidity risk, tax risk, and geographic risk.

In isolation, there’s nothing wrong with a variable annuity (VA). Their benefits include tax-deferred growth, professional money management, numerous investment options, and a contingent death benefit. Severe deficiencies become apparent when VA’s are compared to low cost, tax-efficient investment products such as index funds. In our experience there are very limited circumstances that warrant the purchase of a VA. If an investor already owns a high cost retail VA with a (substantial) gain. If client circumstances are appropriate, a high-cost retail annuity can be exchanged for a no-load, low-cost Institutional Variable Annuity, without incurring a taxable gain.

While Index Annuities provide a tax deferral benefit of the return, the product is so complex, convoluted, and loaded with marketing costs, it’s a virtual certainty an investor won’t earn a competitive return. These products should be completely avoided.

The most advanced products for tax-efficiency are tax-managed passive asset class funds (TMACs). To keep taxes low, there are five primary techniques that TMACs apply: low turnover, expanded securities trading range, dividend management, tax loss harvesting and avoidance of short term capital gain realization.

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)