Optimizing Investment Portfolios to Minimize Taxes

Insights on mitigating tax liability, tax-efficient investing, and the impact of tax reform on investor portfolios.

Taxes have long had a significant impact on investor returns, eroding 1%–2% or more per year.Despite having roughly the same impact on returns as fees, taxes have often not received the attention they should as part of the investment planning, advice and implementation process. This is starting to change, however, as financial professionals become more attuned to the potential effects of taxes on their investment portfolios.

New Tax Law – Higher Taxes?
For equity investors the Tax Cuts and Jobs Act is misleadingly named. Federal tax rates for capital gains2 and qualified dividends3, the sources of most of the returns generated in typical stock portfolios, did not change. In fact, for investors in states with a state income tax, the effective rate actually increased. The limitation on the deductibility of state and local income taxes means that taxes paid on gains and dividends at the state or local level may no longer be deductible.

Anticipating Increased Demand for Tax Efficiency
Higher tax rates mean taxes take a bigger bite out of investor returns. The good news is that tax mitigation techniques can have more of an impact in reducing that tax drag. One common technique is tax loss harvesting4, or the selling of positions that have declined in value to realize those losses and offset other gains. Employing this technique may be especially important now, in part due to the Tax Cuts and Jobs Act having gone into effect January 1, 2018. That, along with the likelihood that recent market volatility has created more opportunities to harvest losses, is likely to result in much bigger demand for this service, which can strain the operations and trading staffs of asset managers that are not prepared.

New Approaches to Tax Management
This heightened focus on after-tax returns may also prompt financial professionals to consider alternatives to mutual funds that offer structures with better tax characteristics. Separately managed accounts seek to avoid the issue of embedded capital gains associated with commingled investment vehicles; they also facilitate customized investment decision making to harvest losses and defer gains. Historically, separately managed accounts were cumbersome to use, but the proliferation of Unified Managed Accounts (UMAs) has removed many of those hurdles. As a result, asset managers may need to consider making their strategies available in other formats such as separate accounts and model delivery relationships.
1 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.

2 A rise in the value of a capital asset that gives it a higher worth than the purchase price.

3 A dividend that falls under capital gains tax rates that are lower than the income tax rates on unqualified, or ordinary, dividends.

4 Selling securities at a loss to offset a capital gains tax liability.

All investing involves risk, including the risk of loss. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

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. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted.  Actual results may vary.

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