DR.CHENJIAZI ZHONG

Astute management of investment-related taxes is a critical piece throughout the portfolio management process; tax consequences severely diminish investors’ spending power and long-term return. For wealthy families and individuals, the differences can amount to millions of dollars a year. As a result, a taxable individual investor has to accept more risk in order to get the same performance as a tax-exempt investor, and therefore, to measure the efficacy of an investment strategy, investors have to look at after-tax returns since they will eventually get to spend after-tax income at retirement.

The taxes associated with investments are income tax, capital gains tax, wealth transfer tax such as estate taxes and gift taxes, and property tax. Investment-related tax should be managed from the perspective of each trade in the portfolio, not only once a year. Sometimes pursing a tax advisor is quite necessary for individual investors to stay on top of their tax situation and the opportunities in any tax code changes.

Although the majority of sophisticated taxable investors have realized the importance of incorporating tax considerations into the process of portfolio management, in fact, not many of them implement portfolio construction in a tax-adjusted manner. Proper management of the tax impact of investment activities will substantially increase the net wealth of individual investors.

How to Manage Taxes?

At the very early stage, the academic world focused on the absolute distinction between active investing and passive investing in studying how to manage investment-related tax effectively. Consequently, seeking tax-exempt investments come at the expense of lower returns, restricted liquidity, and investors’ less control over these investments.

Effective tax-management techniques are more than just compromising; instead, they pay attention to the trade-off between risk, return, and the taxes whenever a buy or sell decision is made.

Basic Tax-Management Techniques

Basic tax-management techniques focus on how to select appropriate investment accounts and investment vehicles. In the United States, the tax-exempt investment accounts that investors typically use to defer the realization of gains include:

1. Regular IRA – in a traditional IRA, individual investors are allowed to contribute 100 percent of compensation up to a certain maximum. The contributions may be tax-deductible but the withdrawals are taxable.
2. Roth IRA, in which contributions are not tax deductible but qualified withdrawals tax-free.
3. Annuities, which individual investors primarily use as a means of securing steady cash flows during retirement years.
4. Employer’s 401(k) and 403(b) plans.

Aside from investment accounts, each investment vehicle has a different tax implication. Some are designed to be tax-efficient, while some expose taxable investors to a much greater tax liability.

Mutual funds are notoriously bad choices from the tax perspective. On one hand, the high fund turnover will create significant taxable gains. On the other, since interest, dividends, and realized capital gains are typically distributed pro-rata to mutual fund shareholders annually, it is fairly likely that investors would ultimately pay taxes on the gains that they did not even participate.

ETFs are generally more efficient than mutual funds because they trade intra-day. Beyond that, most ETFs are passively managed, which will translate into low portfolio turnover. More importantly, ETFs trade on the secondary market so they do not need to be sold for redemptions.

In partnership structures, with the manager as the general partner (GP) and the fund investors as limited partner (LP), investor pay taxes that incurred within the portfolio through the IRS K1 document. Investors of hedge funds, for instance, usually ignore the inherent high taxes on the partnership structure.

Separate account is a widely-used investment vehicle to improve tax-efficiency, largely due to its flexibility in structuring investments, and investors’ relative discretion in terms of buy and sell decisions.

Furthermore, it is essential for individual investors to know that:

• Investment gains are only taxed if the security or financial asset is sold, whereas the tax liability is deferred as long as the asset is being held.
• If the holding period is longer than twelve months, the capital gains resulted from the sale of a security are taxed at a lower tax rate.
• For dividends, they may also qualify for a lower tax rate if the investor holds the equity longer than 61 days.
• Some tax-aware investment managers also utilize HIFO (highest in, first out) tax-lot accounting to sell securities. For some entities, the HIFO method will decrease the taxable income for a period of time because the inventories are always recorded the most expensive ones.

Advanced Tax-Management Techniques

Advanced tax-management strategies aim to enhance overall investment performance through asset allocation and portfolio construction.

Asset allocation is the core philosophy of successful portfolio building, and it is effective for almost all the endowments and pension plans. However, when applying the same asset allocation strategies to individual investors’ cases, it would not work because the projections of each asset class largely neglect the tax consequences, which will ultimately shift current target allocation and further impact future portfolio rebalancing.

The first step is to establish an after-tax asset allocation framework to allocate to each asset in the most tax-efficient manner. Tax-aware investors estimate the risk and return characteristics of various allocation alternatives utilizing the after-tax return inputs for their taxable investment accounts and pre-tax return inputs for the tax-deferred accounts.

Second, identify and select tax-aware asset managers. In most circumstance, these asset managers share a few in common: 1) their portfolios exhibit low turnover, 2) they are conscious of holding periods, 3) they avoid incurring short-term capital gains whenever it is possible, 4) they keep trading to a minimum because the more they trade, the higher the tax liability investors will suffer.

Moreover, it is necessary to create a tax-constraint Investment Policy Statement (IPS), that is, an investment plan based on after-tax perspective.

Furthermore, the concept of asset location states that tax-aware investors should not place nontaxable investments in tax-exempt accounts. According to this principle, investors can include bonds in the tax-deferred account, because bonds are taxed at the ordinary income, which can be much higher than the rate on stock dividends. Then keep equities in the taxable account as equities are more flexible and amendable from the tax-management perspective.

References:

Tax-Efficient Investing in Theory and Practice (P5) by Paul Bouchey White Paper Spring 2010