Tax efficient portfolio management

In addition to the two main investing considerations, risk and return, tax issues rightly concern most investors. Taxes cut into returns and slow down compounding growth, and doing a poor job managing them can waste the gains it took so long to accumulate. Therefore, it is important to pursue tax efficiency in any portfolio where tax costs play a part. You may be surprised to read how many issues you need to consider and why we feel having a professional on your side can really pay off.

Not all investors face the same tax circumstances, so there is no one-size-fits-all approach to tax management. The following brief list highlights some issues you should think through carefully to maximize your portfolio’s tax efficiency:

  • Country or state of residence
  • Current tax rate versus expected tax rate post-retirement
  • Capital losses carried forward from prior years
  • The mix of taxable and tax-advantaged accounts
  • Trading frequency
  • Fund distributions and fund selection
  • Foreign tax credits

The above list should get you thinking not only about the complexities, but also the opportunities your unique situation presents. Knowing your current tax situation impacts how you choose to invest now, and accurately projecting future tax consequences helps determines which trades to make as well as when to make them.

Country or state of residence

Tax rates on income and capital gains differ by whether you must pay taxes to the US or Canada and change based on the state or province where you reside. For example, certain kinds of bonds issued by state and local governments avoid federal income tax completely in the US and can also get around state income tax if the investor lives in the issuing state. But in Canada there are no equivalent investments to these kinds of bonds.

In the US, long-term capital gains may incur a federal tax rate of 0%, 15%, 20% or more (depending on income level). State rates vary and are in addition to the federal rates. In Canada, investors pay their regular federal and provincial income tax rates on 50% of their capital gains. Moreover, because Canada and the US have a tax treaty, sometimes  the rules can overlap or even provide opportunities to time gains to avoid tax in one country as often happens when clients move from Canada to the US.

Current versus future expected tax rates

If you expect your post-retirement income tax rates to be lower than your current rates, it may pay to delay realizing capital gains and certain times of income where you have the option to manage timing. One common way investors do this is by contributing to tax-deferred accounts (IRAs, RRSPs, 401(k)s, deferred compensation arrangements, etc.) during their high-tax years so they can withdraw those assets later at a lower tax rate.

On the other hand, if you do not expect your future tax rates to be lower, then you may choose to invest in a tax-free account like a Roth or TFSA, and you may even accelerate certain types of income to maximize the amount you can earn before hitting the next tax bracket.

Capital losses carried over from prior years

Everyone has a bad investment year from time to time. When you lose money on an investment and choose to sell it, you realize a capital loss. If you have insufficient gains in the current year to offset that loss, you can carry it forward for use against future years’ gains. Many people started 2010 with a capital loss carryover from the terrible markets of 2008 and 2009. Those same investors got to enjoy some relief, however, from paying taxes on gains over the next couple of years. The losses on the books canceled the gains taken up to the point of depleting the losses.

Toward the end of each year, investment advisors can review which investments have appreciated in value and which have declined. This affords them the opportunity to sell the securities or funds which have decreased in value to offset gains taken in other parts of the portfolio. Any excess can be carried forward to offset future gains, leading to a more tax-efficient experience.

Of course, selling investments which are down involves a few complications. For example, both the US and Canadian tax codes prohibit taking a loss on the tax return if the asset sold gets replaced by a substantially identical security within 30 days. So the astute investor must have a substitute security available which differs enough from the asset sold to handle this contingency or else stay out of the market and risk missing an upturn.

In certain markets, we might advise taking capital gains rather than losses. One must know the type of gain to do this well. Long-term capital gains in the US carry a lower tax rate than short-term gains, and collectibles (e.g., gold) have their own rate which can fall between. The tax code in the US involves a process of netting like gains against like losses to arrive at a net gain or loss, so one might carelessly incur a higher tax rate than expected by forgetting to match gains and losses properly.

The mix of taxable and tax-advantaged accounts

“Asset location” refers to choosing specific kinds of assets for specific account types in order to take as much advantage of the tax code as possible. In the US, for example, bond interest on government, corporate, and other taxable bonds incurs regular income tax rates. Long-term capital gains, however, usually face a lower tax rate. Inside a traditional retirement account like an IRA, RRSP or 401(k), most withdrawals incur regular income tax rates no matter their source. It makes sense to hold the interest-bearing investments in the retirement account and the gain-producing investments in the taxable account so that lower capital gains rates can apply to stock gains, while no additional tax applies to the bond interest.

Other issues affecting asset location include the ability to take tax losses in a taxable account (but not in a retirement account, generally), and tax-free provisions of the Roth IRA or TFSA, which may lead to holding the highest-return-potential investments there. As you can see, an investor faces many tradeoffs to determine the best place for each asset, and an advisor can help navigate them more efficiently.

Trading frequency

Generally speaking, more frequent trades lead to higher tax bills. Active funds (meaning funds which attempt to beat the market by trading in and out of stocks or bonds) will likely make higher tax distributions at the end of the year than funds which purchase a broad basket of securities and hold them for the long term, with minimal trading. Your advisor, too, can make frequent or infrequent changes among the investments in the portfolio.

We feel that frequent trading and even too-frequent rebalancing brings only minimal benefit and may actually harm returns due to the costs involved. Taking a long-term view that involves only occasional trading helps to keep tax costs down and keep investors focused on their actual portfolio goals rather than the current market noise.

Fund distributions and fund selection

In the US, mutual funds must pass through taxable income and gains to the shareholders each year. Most of them pay income (e.g., dividends) quarterly or monthly and capital gains only annually. They announce their expected distributions sometimes with very little lead time, but in the cases where the advisor knows exactly what will be paid and how it will be classified (e.g., income, long-term gains, short-term gains, return of capital), a window opens to determine whether the tax bill for selling the asset will exceed the tax bill for holding on through the distribution. Note that in the US gains must be held for at least one year and a day to receive the lower tax rates; gains held for a year or less are tax as ordinary income. Theoretically, and in a perfectly stable market, the fund’s share price drops by exactly the amount of the per-share distribution on the “ex date” for that distribution. By comparing the all-in tax and trading cost of selling prior to the ex date and repurchasing on the ex date to the cost of holding onto the fund, an investor or advisor may ferret out an additional tax savings. However, this approach comes with some risks and requires careful planning and execution.

Probably the best defense against excessive fund distributions comes from picking funds which have tax-sensitive approaches in the first place. As already mentioned, active managers engage in frequent trading, and they may not formally pursue tax efficiency. Passive funds (funds which buy and hold large groups of stocks) trade less and often pay out lower tax distributions than their active counterparts. Exchange-traded funds use a unique structure which allows them to pay out appreciated securities and in so doing wipe capital gains off the books all together. Your advisor should know how each fund ranks in terms of its tax efficiency so that your portfolio considers tax management from the beginning.

Foreign tax credits

During a cross-border move, you may accumulate credits for taxes paid to one country which were not due in the other country. When this happens, you can often gear your investment portfolio toward the types of assets which will help you make use of those tax credits and lower your future tax bills. KeatsConnelly has long specialized in such strategies and can help manage how credits get generated as well as utilized. Many advisors do not know how or may not care to incorporate foreign tax credits into their portfolio management approach.

Other issues

Finally, you must remain aware of changes to your tax rate due to changing jobs or locations, the ever-changing rules governing tax-advantaged arrangements, and how your total financial situation (not just your investment portfolio) can interact to make certain strategies more or less attractive at different times.

Taxes represent the single biggest drag on returns over an investment horizon, so they merit careful attention. Keeping on top of all the issues is a big job, but the numbers show that it’s worth the effort. If you prefer to have professionals with years of experience navigate the complexities for you, we’d like to discuss how KeatsConnelly can help

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