Portfolio Design: Maximizing After-tax Returns

Even when we do everything right – listen to the evidence, invest for the long-term, tune out the market noise – we don’t invest in a vacuum. Ultimately, we need to go beyond the returns, dollar signs, and percentage points and begin to look at our portfolio for what it is:  A means to an end. For most of us, these assets will be liquidated over time and used to fulfill our goals and objectives through retirement. Unfortunately, Uncle Sam is going to want his share. As the saying goes… death and taxes.

So, while you can’t control markets, or influence tax law, you can take steps to maximize what should be everyone’s goal at the end of the day; more cash in your pocket.

Ways to Help Maximize After-tax Returns

Tax-managed Equity Funds

Holding tax-managed funds within a portfolio is an easy and effective way to offset some of the tax consequences associated with mutual funds.  This is accomplished by letting the fund companies do the work for you. Often, these funds are designed to mirror their non-tax-managed counterparts while seeking opportunities to manage around taxable distributions. In this way, fund companies seek to further reduce an investors overall tax burden, while maintaining comparable expected returns.

Looking specifically at a fund company we utilize, Dimensional Fund Advisors accomplishes this goal through the following considerations:

Capital Gains Distributions

  • Avoiding Short-term Capital Gains- Lower turnover within the funds increases long-term holdings.
  • Tax Loss Harvesting – Generating capital losses to offset both short- or long-term capital gains.
  • Tax lot Relief Method – Building up positions through multiple lot purchases, allowing flexibility when selling securities.

Income Distributions

  • Maximize Qualified Dividend Income (QDI) – Non-qualified dividend income is often taxed at ordinary income rates, where QDI may be taxed at lower capital gain rates.

Tax Efficient Asset Location

Avoid holding identical assets across numerous accounts within a portfolio, especially when utilizing a combination of taxable and tax-advantaged accounts. In the same way that each of these accounts can have different tax treatments, each investment can have its own tax rules.

As a rule of thumb, we would prefer to hold tax-inefficient investments within a tax-advantaged account, with the opposite holding true for tax efficient investments. As a result, we are better able to manage the taxable distributions to further enhance the after-tax return of the portfolio.

In general, fixed income (excluding Municipal Bonds and US savings bonds) tend to be on the tax-inefficient side of things, while equities fall into somewhat of a grey area. Depending on investment strategies, equities vary on their tax efficiency. Indexed or passive funds tend to be more efficient than actively managed funds, and the same is true in general of large-cap funds compared to small-cap.

It is important to note, however, that everyone’s situation is unique, and depending on your goals, risk tolerance, time horizon, and tax bracket, you may find the effectiveness of these strategies diminished.

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