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Excellent investment returns don’t matter if you have to send most of your winnings to Uncle Sam. Taxes can be a major drag on investors’ returns, and taking the effort to minimize the bite is well worth the effort. We work to maximize our clients’ after-tax-return by focusing on the following four steps:

1. Make the most of tax-preferred accounts

There are a variety of tax-sheltered accounts available; 401(k)s at work, Traditional IRAs and Roth IRAs for yourself, 529 plans for your kids, and so on, but they are only of value if you use them. We educate our clients on what accounts are available to them and how to use them most effectively. We can advise you on the allocation of your company’s 401(k) plan if you’re an employee, or help you set up an individual 401(k) if you’re self-employed, or perhaps even manage your company’s 401(k) plan if you do not have one yet or you’re not satisfied with it.

2. Practice intelligent asset location among account types

Different assets have different tax treatment; for example, interest from corporate bonds is taxed as ordinary income at the federal and state level, whereas dividends and capital gains from stocks are generally taxed at lower, preferential rates. At the same time, different account types have different tax treatment: a taxable brokerage account will generate taxable income every year from interest, dividends, and capital gains; retirement accounts are sheltered from these annual liabilities, but have different rules about the taxes on money going into or out of the account, depending on if it’s a traditional IRA or Roth IRA, for example.

Asset allocation

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These different rules mean that the same asset will have a different after-tax-expected return, depending on which account it’s placed in, as well as the investor’s marginal tax rate, now and in retirement. Many investors ignore these differences, holding basically the same mix of investments across their accounts, but by carefully optimizing the location of assets among accounts, you can potentially add up to 0.52% to your after-tax return, depending on your tax rate, risk tolerance, and the relative sizes of your taxable and tax-preferred accounts. We explicitly account for after-tax returns and account treatment in our portfolio optimization process.

3. Employ tax-loss harvesting

Inevitably, sometimes investments will lose money, at least over the short term. The silver lining to this downside is that investments trading at a loss can be sold and the loss used to offset positive capital gains income, now or in the future, thus reducing your annual tax bills. We continually monitor our clients’ portfolios for tax-loss harvest opportunities; whenever any security is trading at a significant loss, we will sell it and reinvest the proceeds into a different security in the same asset class. This way, we maintain your portfolio’s overall risk and return profile, while harvesting tax-losses in a manner consistent with IRS rules on this.

Whenever possible, we’ll even stack the deck in your favor, by placing more volatile, and less correlated assets into your taxable account (consistent with your risk tolerance), increasing the likelihood that we’ll be able to take advantage of tax-loss harvesting for you. By practicing a consistent tax-loss harvesting strategy, you can reduce or even eliminate capital gains tax payments for years on end, potentially increasing after-tax returns by as much as 0.80% annually over an investment lifetime for high-income investors.

4. Allocate around low-basis positions to reduce capital gains

Suppose you bought a stock or a mutual fund a long time ago and now it’s worth ten times more than you purchased it for. Congratulations! But now the security is a disproportionate amount of your wealth and your asset allocation is out of balance. A high class problem to have, but still a tough investment decision-making dilemma nonetheless; how do you weigh the tax liability associated with rebalancing against the suboptimality of the concentrated position? Many advisors or automated solutions would simply have you sell no matter what, or follow some other one-size-fits-all rule. We believe actually doing the math and figuring out what’s best for the client is worth it.

Whenever a position is sold for a profit in a taxable account it generates a taxable liability that can be modeled as a negative expected return. This negative return must be weighed against the expected return improvement from rebalancing. If the numbers don’t add up in your favor, we won’t be adding to your tax burden. We also consider alternative solutions; often rebalancing can be done solely within tax-sheltered accounts to accommodate low-basis positions in taxable accounts; if you are making regular contributions to your account and you are over-allocated to a particular asset class, we can simply direct new monies to other asset classes until you are rebalanced without ever having to sell anything.

References

Optimal asset location can have large effects on investors’ after-tax returns: “Alpha, Beta, and Now… Gamma” by Blanchett and Kaplan (2013)

Active tax loss harvesting can greatly add to investors’ after-tax returns: “Loss Harvesting: What’s it Worth to the Taxable Investor?” by Arnott, Berkin, and Ye (2001)