Many people are once again starting to see some of their mutual funds pass along taxable income. Such is the “benefit” of recent improvements in the returns of various markets. Some of us haven’t seen taxable income from our investments for awhile so it’s time again to review what it means to exercise good tax management in an investment portfolio not already in a tax-deferred arrangement (IRA, 401(k), etc).
Right now if your investments are held in a taxable account you might be exposed to paying tax regardless of whether or not you took money out of your account. This could be a bummer because now you might actually have to take money out in order to pay the tax , reducing the amount left in the account to grow into the future.
So good tax management tries to avoid or reduce this problem by doing three things:
1. Timing of portfolio changes. Good tax management models pick appropriate times to buy/sell securities so that it doesn’t lead to a gain. For example, bad tax management might rebalance your portfolio on a quarterly basis no matter what, possibly triggering a gain to you and exposing you to tax. Good tax management would say STOP with the rebalancing merely because it is the start of a new quarter if it would create an unnecessary tax liability. Good tax management is more sensitive to timing the intricate interior changes to your portfolio.
2. Tax-lot activity. Basically, tax-lot activity is a portfolio-management function that searches your entire portfolio to try and harvest any losses (which reduce your tax liability) to counter any taxes caused by growth. This obviously requires very detailed awareness of all the elements of your portfolio on a regular (i.e. constant basis). Good tax management follows a disciplined search for opportunistic offsets to tax liabilities.
3. Choosing tax-advantaged vehicles. Good tax management looks for acquiring underlying securities that might be less likely to create taxable gains. Choosing stocks and funds that don’t pay dividends, that don’t produce realized capital gains, that aren’t subject to federal taxation, are examples of how to create a good tax-managed portfolio from the ground up. Good tax management selects specific investments most likely to be tax-friendly.
The overall goal is to build the entire model around protecting your investments against tax without eroding the return performance of the portfolio. Careful selection of the right asset managers who are specifically good at tax management is absolutely critical. Like any specialty in any industry it takes years of proven performance to demonstrate a real talent. You can’t just “wing it” when it comes to good long-term tax management.
