Tax Management Tips for Investment Portfolios

One of the most effective avenues to a secure retirement is appropriate tax management. CIO John Cunnison points out strategies that could reduce your tax bill.
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By John Cunnison, CFA®

Along with investing early and maintaining a well-diversified portfolio, one of the most effective avenues to a secure retirement is appropriate tax management. This concept spans the gamut, from fund choices to strategy options, asset location, and the relative benefits of a dividend.

John Cunnison

John Cunnison, CFA

ETFs vs. Mutual Funds

When comparing ETFs to mutual funds, there are important tax ramifications to consider. Some ETFs can offer attractive tax advantages, avoiding many capital gains that mutual funds can’t. But it’s important to identify which ETFs will best utilize those advantages. Although the mechanics behind ETF tax efficiency are quite complex, the following is a simplified explanation:

If an ETF plans to reduce or eliminate a position that has experienced a big gain, it can often exchange that position for an equivalent value in another holding, deferring the gain rather than realizing it in the current year through a simple sale. In this scenario, there would still be a difference between the cost basis and market value in the ETF, but investors wouldn’t realize that gain until they sold shares of the fund. ETFs can also harvest losses to offset gains that cannot be deferred through the mechanism described above.

Because the power of this tax advantage is in the ability to defer accumulated gains over many years, it is important to pick an ETF with a stable parent company that you believe will be in business for as long as you will be investing.

Mutual funds can also provide tax advantages, but typically only if tax-loss harvesting is part of the fund’s mandate. This means that when a mutual fund is trading in the normal course of business, it is also focusing on minimizing distributed capital gains. If the fund is preparing to execute a trade that will generate a gain, it will assess other holdings within the fund to identify opportunities to harvest offsetting losses.

How do you know if tax-loss harvesting is part of a mutual fund’s management strategy? Typically, it will either be noted in the name of the fund itself, or the prospectus will clearly state that the fund is designed to provide tax-advantaged portfolio management. If you are interested in owning a particular mutual fund in a taxable investment account, I would recommend learning about any tax advantages it might provide.

Gaining Momentum

Momentum strategies, which are gaining in popularity, offer another option to consider. I often think of momentum as growth investing done right. While momentum can provide an attractive, systematic approach to growth stocks, proper momentum management requires high turnover, which means significant transaction costs and substantial realized capital gains. For this reason, momentum strategies should only be utilized within qualified accounts, SMAs or ETFs that know how to effectively defer capital gains.

For those who are less familiar with momentum, it is a strategy that takes advantage of a well-documented phenomenon, where declining stocks continue to decline and rising stocks continue to rise beyond their “intrinsic value.” Momentum can affect stocks across the spectrum, even those that are traditionally value-oriented names.

The key to success with momentum investing is to identify stocks that are trending up, invest in those stocks and then exit before the trend slows or ceases. Accordingly, the strategy entails extensive buying and selling. Whenever you’re trading frequently, transaction and tax costs will be high. Although momentum might seem attractive on the surface, many of the earnings made possible by a momentum strategy can be wiped out by costs, especially capital gains. This is why the investment vehicle is crucial for successful momentum investing.

We’re actually in a period now where momentum strategies are performing very well. Momentum is one of the best complements to a value-oriented strategy because the two strategies tend to do well at different times. Coupling a momentum strategy with a value strategy puts a different spin on diversification, applying the concept to strategies rather than just holdings or asset types.

Asset Location

Asset location is another strategy that can yield significant benefits. This concept is well known to many investors, but they might underestimate the patience required to fully realize the benefits. Asset location involves putting fast-growing assets (typically stocks) into non-qualified accounts for capital-gain tax treatment; and slower-growing, income-generating assets (typically bonds) into qualified accounts like IRAs that will be taxed at income rates.

Over long periods of time, the benefits of having the majority of portfolio growth taxed at a lower rate can be significant. Realizing these benefits, however, requires that investments are held for decades with little active trading. How many investor portfolios have basically the same holdings as 20 or 30 years ago? Not many, which represents both the challenge and opportunity of this strategy. Like capturing momentum, the tax-deferral mechanism in some ETFs can increase the odds that asset location will yield these benefits for long-term investors.

The Deal with Dividends

That brings me to another important tax-management topic — dividends, which I believe are somewhat misunderstood. Many investors transitioning into retirement gravitate toward dividend-paying stocks as a source of income, and they tend to want to avoid dipping into the principal value of their portfolios.

It is important to remember that when a company makes a profit, it can either be distributed to shareholders in the form of a dividend or reinvested. If the company does push out a dividend, then its value will decrease by exactly the amount of that dividend, and the dividend would be taxable this year. Whereas if the company reinvests its profit, an investor would still benefit but in the form of a capital gain that can be deferred.

From a tax perspective, it’s preferable for investors if a company invests in new projects that will likely generate a higher return than its cost of capital. This way, investors can increase their wealth, but the timing of when to pay tax on that wealth is in the hands of each investor. Generally speaking, companies get punished for reducing dividends because investors like to have nice, steady dividend streams. But in an ideal world, a company would be varying its dividend all the time based on the relative appeal of potential projects.

So we talk about the idea of a “synthetic dividend” with our clients. This basically means that a client tells us how much money they’ll need for a given year in retirement, and we’ll reach that figure through a combination of whatever dividends they happen to receive and selling shares to make up the remainder. Approaching retirement income with no preference for dividends allows for tax deferral at the margins, while also enabling investors to be unconstrained in their investment strategy. In other words, they will no longer be constrained by a preference for dividend-paying stocks.

In summary, the above points represent just a sampling of the myriad tax considerations inherent within a well-managed portfolio. Whether you choose to consult with an expert financial advisor or prefer to be your own guide, remember that minimizing taxes can be just as pivotal to a secure retirement as any inspired investment selections are.

About the author: John Cunnison, CFA®

John Cunnison, CFA®, is vice president and chief investment officer at Baker Boyer in Walla Walla, Washington. In spearheading investment management at Baker Boyer, John works to construct and maintain tax-efficient portfolios. Among his areas of expertise are economic trends, behavioral finance, portfolio construction, and factor- and evidence-based investing.