Four Approaches to Lessen Taxes on Your Investment Gains

This time of year, taxes are top of mind for most investors. Ultimately, having a tax bill is a result of good returns and cannot be avoided completely. “Don’t let the tax tail wag the dog,” we might say.

That said, it’s possible to structure your investments to improve your tax posture—in ways that don’t necessarily mean a different overall risk profile or allocation mix. Here are four approaches to know and discuss with your advisor.

Tax budgeting

The first step is to set a tax budget. Decide for an average year what’s a reasonable amount of capital gains you can accept and pay taxes on. We typically start with a percentage of your overall portfolio value and adjust depending on specific circumstances. We revisit the tax budget with clients on a regular basis as it can change due to a big tax event (either positive or negative) outside an investment portfolio.

Having a tax budget helps with cash flow planning, allows for reasonable trading to maximize opportunities, creates opportunities for rebalancing, and eliminates surprises at the end of the year.

Asset location

Now that you have set your budget, the next question is how can we stretch it as far as possible?

One of the most impactful strategies to use is “asset location.” Most investors have multiple pools of investments that have different tax registrations—for example, a 401(k), perhaps a Roth IRA, or an IRA Rollover from a previous employer and some investments in a joint (taxable) account. If you have an overall asset allocation target, and assuming they have similar purposes or goals, there is no reason each of them must hold the exact same securities.

We suggest locating the least efficient investments in the tax-deferred investment pools. For example, mutual funds, can be placed in your 401(k) plan to the degree possible. Further, mutual funds that have higher growth or turnover characteristics—like small company stock or emerging markets funds, or even high yield bond funds—could be placed in your Roth IRA accounts first, then in the 401(k) or Rollover accounts and lastly in the joint account if the allocation needs it.

The rationale for that order is that capital gains and interest income are not taxed in Roth accounts, IRA Rollovers or 401(k) accounts but are taxed in the joint account. The additional nuance is that eventually your 401(k) and IRA Rollover accounts are going to require distributions, so if you grow them so much that tax eventually might become an issue, using the Roth IRA, which does not require a distribution, might give you more flexibility—and a lower tax burden—in the future.

Tax efficiency

The third strategy is to use as many tax-efficient investments as possible, assuming the tax-adjusted returns match or beat other investment choices. We believe both active and passive investment vehicles have their place, depending on the client situation. Using index funds, ETFs and individual securities as much as possible to fit your allocation—and placing them in your taxable accounts rather than your IRAs or tax-deferred investments—may stretch your tax budget a little further.

Tax harvesting

Lastly, use tax harvesting during downdrafts in the market or within your security portfolios. We actively harvest taxes during a general downturn or a security-specific issue.

• During a general downturn, you can sell parts of the market that are down or between parts of the portfolio and still keep your overall risk and return profile intact.
• For a stock-specific downturn, it’s often possible to swap securities that are similar. For example, perhaps there was a business specific event that caused Kimberly Clark to lose value since your purchase of it. Your advisor may harvest that loss and invest in Proctor and Gamble, which will likely have a similar return profile (at least for a short period of time).

No one likes to lose money, but if you can get a tax benefit from a loss and keep your potential return the same it just makes sense to do so. You do, however, need to pay attention to IRS wash rules if you wish to reinvest in the security you sold.

Planning ahead

While taxes are still on your mind, talk with your advisor about how to budget for next year and make use of some simple tax management strategies to lessen the impact. Through planning, we might just be able to take those lemons and make lemonade.