Thwarting the Taxman

[ Note: as you read this, play "TAXMAN" by the beatles ] 


Taxes – even one of the greatest rock and roll bands of all time couldn’t help but address this thorny issue head on!  It’s funny, but one of the most generally worn maxims in investing is that you must take risk to earn returns.  While that is true on a general level – we all can’t sit in treasury bills for 30 years and expect a lush retirement – there are other ways to enhance a portfolio’s likelihood of success that do not involve taking more risk.  One of the most underrated features of a successful investment portfolio is tax efficiency and tax coordination.  By simply being mindful of tax consequences, your portfolio can add a tremendous amount of value that is completely unrelated to market performance. 

One of our favorite ways is to minimize taxes is by simply locating the right assets in the right places.  Now that’s music to anyone’s ears and can be expected to create value by enhancing your after-tax cash flow.  Unlike the random performance of the financial markets, this is one thing you can control!  While we can’t change tax rates, we can certainly change where we locate specific assets and how we make investment decisions, to minimize the taxman’s take.

First, we seek to reduce taxes by overweighting tax-efficient asset classes in taxable accounts, including the use of municipal bonds and low-turnover stock index funds.  Since asset appreciation isn’t taxed until securities are sold, these investments are essentially tax deferred (except some of the interest and dividend income).  Meanwhile, higher-yielding investments such as real estate investment trusts and dividend aristocrats are ideally held in retirement accounts such as IRAs and 401(k)s because the income generated can be deferred until retirement withdrawals.    

Second, because bond income is taxed annually and at higher ordinary income rates, we seek to own a greater portion of your fixed income in qualified retirement accounts.  As a bonus, you might also be in a lower tax bracket in retirement and get some tax arbitrage during your withdrawal period.  Regardless, this income would be subject to ordinary income tax rates just like in a taxable account, so at least you get the tax deferral for free.

In addition, by holding income-producing investments like bonds in a qualified retirement vehicle, you free up more room for appreciating assets such as stocks in your taxable account.  Thus, if you don’t deplete your taxable account before passing away, any heirs would benefit from a full step up in cost basis.  And if you are like most people and need to sell stocks to fund your lifestyle in retirement, you’ll still benefit from the lower capital gains rates (versus the higher ordinary income rates) while primarily controlling when and what gains/losses are realized.

Lastly, savings vehicles like Roth IRAs should be geared for growth, especially because they will be the last accounts you typically draw on, not to mention that unused balances may be left to heirs who can spread the distributions out tax free over their own lifetimes – a wonderful estate planning tool!

Of course, there are many other ways in which we strive to minimize taxes for clients, including continuous tax-loss harvesting, avoiding short-term capital gains, and carefully selecting exchange-traded funds that have turnover buffers to minimize unnecessary capital gains. 

In summary, the fruits of all this planning are nothing to sneeze at.  By managing your multiple accounts at the portfolio level and embracing these tax-saving ideas, the typical investor might expect to enjoy a portfolio with 15% more terminal wealth (or simply choose to retire earlier with the same amount of wealth)!