Key Points:

• Annual tax costs can be one of the biggest detractors to a portfolio’s return over time.

• Effective ways to minimize portfolio tax cost include using tax-efficient investments, and placing certain types of investments in specific accounts based on relative tax efficiency.

• It is important to balance tax minimization with proper portfolio diversification and risk management. If done correctly, an investor can potentially increase after-tax portfolio returns without taking on additional risk.

For taxable investors, the cost of annual taxes paid on portfolio income (i.e., interest and dividends) and capital gains can be one of the biggest detractors to a portfolio’s return. Unfortunately, the amount of portfolio return lost to taxes is not explicitly identified on most types of portfolio performance reports. For this reason, investors can easily forget to periodically review their portfolio to ensure it is tax-efficient. Fortunately, portfolio tax cost is one of the few things that investors can control to some degree. In this article are some considerations for constructing a highly tax-efficient portfolio.

Use Tax-Efficient Investments

Municipal Bonds

One major way to minimize portfolio tax cost is to use investments that are inherently tax-efficient. Municipal bonds are a clear example. Municipal bonds are issued by state and local municipalities to raise money for the construction of things like highways, bridges, and schools. As such, income paid to municipal bond investors is exempt from federal income tax and even some state and local taxes. On the other hand, income paid to investors from other types of bonds, like federal government and corporate bonds, are subject to federal taxes.

Low-Turnover and Tax-Managed Funds

Other types of tax-efficient investments include “low-turnover” funds. Turnover refers to the sale frequency of the securities (i.e., stocks and bonds) within a fund. Generally, “index funds” are lower turnover than “actively-managed funds” because index funds typically hold most of their securities indefinitely. However, not all actively-managed funds exhibit high turnover.

Some actively-managed funds are considered low-turnover because while their managers may sell securities, they do it infrequently. There are also some actively-managed funds that are considered “tax-managed”, which generally means that they have an official secondary mandate to minimize taxes for investors. An example of this would be a fund that always waits until after a year to sell securities at a gain, in order to avoid a higher “short-term” capital gain tax; or they may proactively sell securities at a loss to offset gains in others they wish to sell.

Broad Market Funds

Broad market funds diversify across nearly all types of securities in a market or asset class. An example would include a fund that invests across almost all U.S. stocks (i.e., large, mid, and small sized companies). Broad market funds tend to be more tax-efficient than narrower-focused funds (e.g., small company-only stock funds), because broad market fund managers usually don’t need to unnecessarily sell securities that may no longer meet a narrow mandate, hence having lower turnover. For example, if a small company grows to become a large company, a broad market fund manager doesn’t need to sell it; however, a narrower-focused, small-cap-only stock fund would need to sell the position, because the company no longer meets its small-cap mandate. See Figure 1 for a summary of investment tax-efficiency. See Figure 1 for a summary of investment tax-efficiency.

Place Investments in the Right Types of Accounts

Another way to minimize portfolio tax cost is to implement proper “asset location.” Asset location is the process of placing certain types of investments in specific accounts based on relative tax efficiency. Like different investments, different accounts in a portfolio can have varying degrees of tax-efficiency. For example, relative to brokerage or trust accounts (which are taxable every year), retirement accounts like a 401(k) or an IRA are more tax-efficient, because investments in these accounts can grow tax-deferred and tax-free in some cases.

Tying investments with proper account placement can optimize portfolio tax efficiency. For example, municipal bonds are generally better suited for taxable accounts, while government and corporate bonds are generally better suited for tax-sheltered accounts. Similarly, more tax-efficient funds like broad market index funds, low-turnover funds, or tax-managed funds, are generally better suited for taxable accounts.Another consideration for asset location has less to do with the investments, and more to do with the investor’s situation. How much an investor will need to draw from their taxable or tax-deferred account(s) and their time horizon can have a large impact on asset placement. For example, when frequent sales would be needed to raise cash in an investor’s taxable account for living expenses over a long period, having more income generating bonds and less stocks in the taxable account can help to minimize the amount of capital gains that are recognized over time. (Bonds tend to experience less capital gains than stocks over long time periods). However, when an investor’s time horizon and cash flow needs are uncertain, a balanced mix of stocks and bonds in all the account types may be appropriate.

Our Takeaway

At Capstone, we strongly believe that investors should try to control what they can control. Tax-efficiency is one of the few areas of investing where this is the case. Regardless, maintaining portfolio tax-efficiency is an area of investing that investors often overlook. We continually strive to balance portfolio tax minimization with proper portfolio diversification and risk management. By using investments that are tax-efficient and implementing proper asset location when possible, an investor can potentially increase their after-tax portfolio returns without taking on additional risk.