Portfolio Tax Management Makes a Difference
February 15, 2006By Chris Dardaman, CPA, CFP®, CIMA®, CAIA®
Sometimes important things go on behind the scenes that are very beneficial but seldom known or talked about. This quarter we wanted to give you an insider’s look at some of the ways we add value to our clients’ investment portfolios using innovative tax management strategies.
Our goal is not necessarily to minimize taxes, but instead, to maximize after-tax returns. This is a subtle but important difference which can be illustrated by a simple example. In the income tax system, investments that increase in value or provide income to the investor are inevitably taxed. On the other hand, investments that lose money and/or decrease in value are not taxed. As a result, perhaps the easiest way to minimize one’s investment tax burden is by making poor investments that lose money. Of course that would be a ridiculous strategy, but the point is that we should not let the goal of minimizing taxes override the greater goal of maximizing economic value. In many cases, achieving the highest after-tax return will mean we pay more taxes.
Maximizing after-tax returns begins by examining the tax efficiency of each new investment with a focus on its potential after-tax return, relative to competing investment options. Sometimes the manager with the best pre-tax return does not have the best after-tax return. Equity managers who trade a lot and have a high turnover rate are often less tax-efficient than managers who hold their investments for longer periods of time. Similarly, although municipal bonds generally have lower yields than corporates, their after-tax yield may be much higher because they typically are exempt from federal taxes.
Once we select managers and place them into a portfolio, we continue to work on the goal by minimizing the realization of capital gains, especially short term gains. When selling individual securities from a taxable portfolio, we typically use the HIFO approach, selling the lots with the highest basis first, followed by securities in order of their percentage gain from lowest to highest. We also try to avoid selling investments that have large built-in gains, unless the sale is justified by the incremental expected return from an alternative investment, or is necessary to maintain the portfolio's asset allocation or cash flow objective.
Another strategy we utilize in seeking to maximize after tax returns is to harvest tax losses when prudent. In a well diversified portfolio, there are sometimes portions of the portfolio that have declined during the year. When this results in a loss, we can sell these positions and replace them with similar investments, offsetting gains that may have been realized in other parts of the portfolio. An example of this was in 2001 after 9/11. When the stock market dropped, we sold some positions to create tax losses on paper, purchased similar securities and participated in the recovery as the markets moved back up. Doing this helped lower the taxes for many clients in 2001 and even some future years.
As you might expect, the effectiveness of each of these strategies varies depending on the timing and each client’s specific situation. However, the background of our investment team gives us a built-in sensitivity and expertise in evaluating the tax implications of our investment strategy. Remember, it’s not what you make, but what you keep that matters over the long haul.
