A Year-End Silver Lining?
As with most storm clouds, however, this market environment brought a silver lining for those investors prepared to navigate the more turbulent market conditions and capitalize on available tax management opportunities. Opportunities to tax loss harvest – which is one of the most effective ways to reduce the tax liability generated in investment portfolios – have been harder to come by the past several years, with the market repeatedly setting new highs. However, the return of volatility in 2018 presented more opportunities to harvest losses, conveniently timed to coincide with year-end, when most advisors and investors initiate this.
Capital Gains Dilemmas
For those not paying attention, this past year-end also offered other shoals and rocks that could disrupt a taxable investor’s charted course. As is usually the case, the market volatility prompted many investors to reduce their investments in the equity markets. The subsequent redemptions in commingled investment vehicles led to relatively large capital gains distributions as most portfolios tended to have substantial unrealized gains, even with the pullback in the fourth quarter.
The New Tax Regime and the Year Ahead
Which brings us to 2019. The 2019 tax filing season (for 2018 calendar year tax liabilities) will be the first under the new tax regime ushered in by the Tax Cuts and Jobs Act. Most taxpayers are likely to see an overall reduction in their taxes, but the impact of the new tax code will vary a great deal by individual. For most equity investors the Tax Cuts and Jobs Act is a misnomer. The federal tax rates most relevant to typical equity portfolios – long-term capital gains and dividend rates – did not change. What did change was the introduction of a cap on deductions for state and local taxes, increasing the effective tax rate on capital gains and dividends for any investor subject to that limitation. In other words, the best case scenario is that tax rates on most equity portfolio activity stayed the same but for most higher income investors, the effective rate probably increased.
Maintaining Systematic Tax Efficiency Is Key
The potential for higher tax rates under the new tax regime makes it even more important to employ techniques designed to mitigate the impact of tax liability on investment portfolios. Several academic studies1,2 have suggested that the tax drag on investment portfolios can be 1%–2% or more, and the higher the tax rate, the more tax drag investors are likely to see on their investment returns. Higher tax rates also mean more benefit can be gained through employing these techniques.
One of the most important of these tax management techniques is tax loss harvesting. Doing this once a year at year-end may not be enough. In 2018, November and December presented more loss harvesting opportunities than previous calendar months. In many other years, though, that may not have been the case, despite the fact that there may have been opportunities earlier in the year. Employing a systematic approach throughout the year to take advantage of potential loss harvesting opportunities could lead to much better outcomes.
Beyond Tax Harvesting
Other techniques that can help reduce tax liability include deferring sales on positions with short-term gains until they qualify for long-term and selecting the optimal tax lot when selling part of a position. Market volatility can trigger a need to reposition client portfolios. While this may be necessary, it is critical to consider the tax impact of any decisions. This can include realized gains on assets that are sold, but the potential embedded gains in commingled vehicles being purchased should also be considered.
Maximizing Tax Efficiency in 2019
For investors, it is the return they earn net of fees and net of taxes that ultimately determines how well they achieve their investment objectives. If neglected, taxes can be the Achilles’ heel of an otherwise sound investment plan. The compounded impact of a 1%–2% difference in return over any meaningful time period can be dramatic. Suggestions for 2019, as well as any year, include:
- Don’t wait until year-end to start thinking about taxes. Taxes should be considered throughout the year.
- The implementation of tax considerations can be cumbersome since by necessity they must be customized for each individual client. Consider using investment programs or strategies that can help do this in an efficient manner. Unified Managed Account programs that incorporate tax management and separate account strategies that conduct proactive tax loss harvesting and employ other tax mitigation techniques are options worth considering.
- Tax issues and situations can be complex. If you don’t provide tax planning services for your clients, consider collaborating with their tax advisor or CPA. A coordinated investment and tax plan is likely to generate the best outcome for clients.
2 Longmeier, G. and G. Wotherspoon, “The Value of Tax Efficient Investments: An Analysis of After-Tax Mutual Fund and Index Returns.” The Journal of Wealth Management, Fall 2006.
Natixis Investment Managers does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.
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