“In this world, nothing can be said to be certain, except death and taxes.”1
Ben Franklin’s quote is spot on; nobody can escape the eventuality of paying taxes but that doesn’t mean that you can’t optimize your portfolios to pay less.
Tax season can be a stressful time for investors. It involves tracking down the necessary forms and keeping up with the seemingly ever-changing tax laws. By implementing certain strategies in your portfolio, you can alleviate some of the stress that comes with taxes.
One strategy is to invest in tax-efficient investments, such as index funds, exchange-traded funds (ETF’s), or municipal bonds/funds. These types of funds can potentially lower your tax burden and increase your return. In addition, you want to distinguish between passive and active strategies. Passively managed funds typically have lower turnover rates. A turnover rate is a measure of how frequently a fund replaces its holdings.2 Actively managed funds tend to have higher turnover rates as they trade more often in an effort to beat the market, resulting in capital gains distributions that are subject to taxes. Conversely, a passive fund’s goal is to duplicate the market by mirroring the holdings of its benchmark therefore it doesn’t need to trade as frequently.
ETFs, due to a structural ability, minimize the capital gains that they distribute due to trading. This makes them more tax-efficient than mutual funds. Capital gains distributions from equity mutual funds are typically twice as high as ETF capital gains distributions.3
Another strategy to keep in mind is the use of tax-advantaged accounts versus taxable accounts. Tax-advantaged accounts would be accounts such as a Roth, IRA, or 401k. A taxable account would be your individual brokerage account. The benefit of tax-advantaged accounts like a traditional IRA is that you don’t pay tax in those accounts until you withdraw the money. In the case of a Roth account, since its funded with after tax money, you can enjoy tax free growth and tax-free withdrawals. Determining which one is more beneficial to you depending on your current and expected future tax brackets is key to minimizing your tax bill.
Perhaps the most well known, tax-loss harvesting, is an additional strategy that can be used to reduce the overall tax liability. It involves selling underperforming investments to offset gains from investments that have performed well. Tax-loss harvesting works best in portfolios that have a mix of losing and winning investments and should be utilized within a taxable account.
Pairing all or a combination of the tips that we covered should result in a lesser tax burden. As a client of Fragasso, below is a list of strategies we proactively have in place when allocating your portfolio with a goal of minimizing your tax burden:
- Index funds and other tax efficient investments
- ETF vs Mutual Fund
- Active management vs passive management
- Tax-loss harvesting
- Utilizing tax-efficient accounts where possible
Implementing these strategies can help reduce your tax liability for years to come and make tax season less stressful by ensuring your asset allocation is optimized. Nobody wants to face a large tax bill because of a mistake such as holding a tax-inefficient fund in a taxable account. Here at Fragasso, our in-house portfolio management team employs these strategies, and others, for a holistic approach to asset management.
3 https://www.americancentury.com/insights/understanding-tax-efficiency-etfs/, https://www.morganstanley.com/articles/active-vs-passive-investing, https://www.morningstar.com/articles/1128676/are-you-paying-too-much-in-investment-related-taxes