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Want to mitigate the impact of higher tax rates? Want to better position your portfolio for a higher after-tax return? Want to optimize your investment experience? Here are a few tips:
1. Analyze each investment based on its expected after-tax return
To optimize your investment experience, you must look closely at all your investments. A rigorous and comprehensive analysis can help identify what type of dividend, capital gain or income tax exposure a prospective investment might have.
2. Focus on asset location as well as asset allocation
Asset location will be even more important if tax rates rise. Ideally, tax-inefficient investments should be placed into qualified (non-taxable) accounts such as IRA rollover accounts. Tax-inefficient investments produce short-term capital gains, taxable interest income and dividends. These investments may include taxable bonds, high yield taxable bonds, high yielding equities, real estate investment trusts (REITs) and preferred stock.
Tax-efficient investments that generate very little taxable income, dividends and realized gains should be placed in nonqualified (taxable) accounts because the unrealized gains will not produce an immediate tax liability. Tax-efficient investments include passive index funds, passive exchange traded funds (ETF), tax-exempt bonds, tax-exempt high yield bonds, and master limited partnerships (MLPs). These type of investments may help you optimize your investment experience.
3. Focus on building a synthetic tax-deferred account with taxable monies
The power of tax deferral allows you to more rapidly compound your investment capital. The tax-efficient investments described above may be used to construct a synthetic tax-deferred account to help optimize your investment experience.
The following scenario highlights the power of tax deferral: Consider an initial $1 million investment that compounds at a 6 percent after-tax return over 30 years, growing to $5.7 million. That same investment grows to only $3.4 million if it lacks the tax-deferral shield, which is subject to a 31 percent tax. That’s a $2.3 million difference! It’s well worth the effort to maximize your investment experience.
4. In taxable accounts, when investing in equities, use passive investment funds (index funds and passive ETFs) versus active investment funds
Passive index funds and passive ETFs historically have had relatively little portfolio turnover and have generated few realized gains that need to be passed along to shareholders. This pattern results in relatively low tax exposure.
Actively managed funds have significantly more turnover and therefore accelerate capital gains. This pattern generates relatively larger capital gain distributions (both short-term and long-term capital gains) to shareholders, often creating large tax liabilities. These tax liabilities reduce after-tax returns.
5. Focus on proactively harvesting losses
Proactively harvesting losses on a regular basis from your taxable portfolio may be another critical strategy to maximize the overall after-tax return of your investment portfolio. These realized losses may be used to offset both short- and long-term realized gains as well as some ordinary income.
This strategy can be employed by investors or their advisors, or by an after-tax index manager who manages these types of investment portfolios with the hope of maximizing your investment experience.
These five key steps can help investors have a better, more robust and successful after-tax investment experience. Do you have other strategies to optimize your investment experience?
Jim Hagedorn, CFA, Managing Partner of Chicago Partners Investment Group is featured in Worth® Leading Wealth AdvisorsTM, a special section of WORTH® magazine from where this article was reprinted. Worth®, a Sandow Media publication, is a financial publisher and does not recommend or endorse investment, legal or tax advisors, investment strategies or particular investments.