Financial Boot Camp Series: Focus on What You Can Control to Increase After-Tax Performance

2020 has certainly been an interesting year and again has reminded investors that they only have direct control over a precious few variables. These include how aggressive or conservative their portfolio is constructed, in which accounts they hold various investments, and when and how they buy or sell investments. The other components of investing, including public policy, tax code, market sentiment, and the performance of capital markets, are largely beyond the control or influence of individual investors. In this article, we focus our guidance on the areas that investors can control to increase their after-tax rate of return.

Tax-Inefficient Investments in Retirement Accounts 

The first step in improving after-tax rates of return is understanding how various investments are taxed and their associated tax rates. We view investments taxed at ordinary income rates (relative to capital gains tax), such as taxable bonds and high-yield bonds, to be tax-inefficient investments. Therefore, our general preference is to hold tax-inefficient assets inside tax-deferred accounts like an individual retirement account (IRA) or an employer qualified plan. Holding tax-inefficient assets inside tax-deferred accounts eliminates associated ordinary income tax; thereby, increasing an investor’s after-tax rate of return.

Efficient Taxable Investing

When considering investment holdings within taxable (brokerage) accounts, an investor should recognize potential capital gain exposure as well as the tax benefits of municipal bonds.

Mutual funds incur capital gains by selling a position for a realized gain. If at the end of the year the fund has a net realized gain (realized gains larger than realized losses), this amount is distributed to the fund’s shareholders as a capital gains distribution. Generally, capital gains distributions are made toward the end of the calendar year.

ETFs and index funds typically generate smaller capital gains distributions compared to mutual funds. ETFs are able to transact on an in-kind basis compared to cash inside of a mutual fund, resulting in lower capital gains and distributions. In addition, index funds typically have lower turnover (buying and selling activity), again resulting in lower capital gains and year-end distributions. With this understanding of capital gains distributions, our preference is to hold ETF and equity index investments within taxable accounts given their more advantageous capital gains distribution exposure.

In addition, to the extent that investors seek to hold fixed income exposure within their taxable brokerage accounts, we would typically suggest municipal bonds given their favorable tax treatment. In general, interest paid on municipal bonds is exempt from federal taxes, and sometimes state and local taxes as well. In the current low interest rate environment, municipal bonds have at times been yielding more than taxable bonds on a pre-tax basis. Layer in the added tax benefit of municipal bonds not being subject to the Net Investment Income Tax, and one can see how municipal bonds improve after-tax performance.

Tax-Loss Harvesting Opportunities

Our final strategy to increase after-tax investor performance is tax-loss harvesting. Tax-loss harvesting is the selling of a security at a capital loss with sale proceeds simultaneously used to purchase a similar asset to maintain current portfolio exposure. 

The IRS stipulates that an investor must wait at least 30 days before re-purchasing the investment sold at a loss; otherwise, a wash sale is triggered and the capital loss harvested is voided and added back to the investor’s initial investment basis in the position.  

Tax-loss harvesting is a fairly simple planning strategy, but in our opinion, is often overlooked or not executed properly. Tax-loss harvesting implemented effectively allows investors to maintain market exposure, while capturing capital losses that can be used to offset other capital gains during that tax year and/or deduct up to $3,000 of capital losses against taxable income on their tax return. 

As investors, we are always looking for opportunities to increase our investment performance. Awareness of how various investments are taxed, constructing a portfolio to minimize your tax liability and capturing capital losses while staying fully invested are effective strategies to improving after-tax rates of return. 

If you are looking for ways to increase your after-tax investment returns, one of our Schneider Downs Wealth Management Advisors would welcome the opportunity to have a conversation with you to discuss further.

Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.