Taxes Do Matter

Key points I want you to take away from this post are:

• In a low return and increasing tax rate world, the tax drag is increasingly important

• Tax efficiency starts with initial portfolio design

• An effective tax strategy carries on for the life of the portfolio.

Where We Are At
The last several years have been extremely challenging for investors. We are currently in a very low interest rate environment. Many respected experts think long-term returns for several asset classes will continue to be lower going forward than historical norms. Given that so much is unknown regarding the future performance of a particular investment strategy, not taking advantage of what is known, i.e. the tax impact, is leaving valuable information on the table. If future investment returns continue to be lower than historical norms, working on maintaining a tax efficient process will help contribute to a larger portion of the real net return. Compounding this circumstance are the likely increases in tax rates at some point in time in the future which will be necessary to address Federal and State budget and debt needs.

Upon Inception
Tax efficiency starts upon portfolio inception. While it is difficult to predict future tax rates, steps can be taken at the point of starting a portfolio strategy which can help insulate against current and future taxes. For example most equity mutual funds are inherently tax inefficient and should be avoided for the most part in taxable accounts. (We do make an exception for a few tax managed equity funds we use in taxable accounts.) We prefer to use more tax efficient exchange traded funds (ETFs) in taxable accounts. If you have a Roth IRA, we should take advantage of the tax free aspect of that account to stock up on your highest expected return assets or perhaps some inherently tax inefficient assets which can be sheltered by the completely tax free nature of a Roth. We generally prefer to hold a larger portion of income producing bonds and high dividend paying REITs in tax deferred accounts like a traditional IRA or 401k plan. Once an asset allocation is determined, working on “asset location” or which investments go into which type of account, is the next logical step.

Carry On
Keeping a portfolio focused on providing suitable after-tax returns takes ongoing discipline. We work on rebalancing portfolios as tax efficiently as possible, often rebalancing the entire portfolio by trading assets within the tax sheltered accounts to avoid creating taxable capital gains. We are inclined to realize losses in taxable accounts in order use these captured losses at a later time to eliminate the tax burden of realized gains. We use specific tax lot identification in all taxable accounts which allows us to clearly identify the tax impact of any investment security sale in client taxable accounts and to seek the most tax efficient combination of tax lots when we do sell.

While I did start by saying taxes do matter and that they are an integral part of the investment decision making process, I do think there are examples when the tax tail should not wag the investment dog. One clear example is when an investor has a concentrated holding with large embedded gains. While the investment industry has offered some (usually commission laden) strategies, most often selling a reasonable portion of the asset to reduce risk is the logical and prudent choice. Also, if a portfolio’s riskier assets have increased appreciably; taxable capital gains may have to be realized to keep a portfolio within acceptable risk tolerance levels.

What Can Be Done Now?
We believe tax efficient investing is an ongoing process. However given the likelihood of higher tax rates in the future, perhaps in the very near future, we think two specific options should be considered.

As touched upon above, investors holding large concentrated positions with embedded capital gains should seriously consider decreasing their positions in 2012 rather than deferring to a later date in order to capture current historically low capital gains tax rates. As an aside, if you are making a donation, consider donating your appreciated stocks rather than cash to avoid capital gains.

We are recommending young affluent investors and investors who have both the desire and the means to leave an estate to consider a Roth IRA conversion. Investors can convert their Traditional IRA into a Roth IRA, paying ordinary taxes on the pretax IRA contributions converted into a Roth IRA. For younger investors, this conversion can represent a tax free pool of assets which can potentially appreciate free of any tax burden over the next several years. For investors looking for a potentially effective estate transfer vehicle converting a Traditional IRA into a Roth and paying taxes up front could allow for an estate tax-free transfer of wealth with tax-free distributions over several years for the heirs. These examples are presented at a very high level.

A Roth conversion is a particularly good strategy if you think your overall tax rate will be higher later in life rather than now. This assumption goes against conventional wisdom that investors will likely be in a lower tax bracket when they retire. With the likelihood that tax rates will increase, we think that assumption is increasingly challenged. Also, we think there are ways to take advantage of the completely tax fee aspects of the Roth IRA and place higher expected return assets in the Roth. Finally, placing assets in the Roth, shelters your assets from future taxable required minimum withdrawals which can offer tax savings in the future.

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