With April 15 upon us, investors have been forced to focus on a subject some would prefer to avoid altogether: taxes.
While many investors use tax-sheltered savings accounts such as IRAs and 401(k)s, and municipal bonds for tax-efficient bond investing, surprisingly few invest in tax-managed funds for the equities they hold in taxable accounts.
Perhaps this was understandable when top tax rates on capital gains and dividends were only 15 percent and equity markets were generating strong returns. But tax rates have been going up, and with the national debt plus government spending on entitlement programs already at high levels, and set to rise further, it's likely that tax rates on equities will continue to increase. The easy stock market gains following the Great Recession are over and bond yields are at rock-bottom levels, so investors have to make their money work much harder than before.
However painful, tax is a costly topic to neglect and there are ways that equity investors can potentially reduce their tax bills substantially. Some investors believe that indexing, either through funds or ETFs, is tax efficient. While indexing is more tax-efficient than many active funds, we believe it falls well short of what can be achieved with a systematic approach to tax management. Indexing also offers no opportunity to benefit from superior stock selection.
Here are some ways investors can minimize taxes on their equities:
Defer realizing gains. Avoid realizing capital gains by selling shares of winners unless this can be offset by an equivalent capital loss from losers. There are circumstances that, on occasion, justify selling a winner and realizing capital gains even when losses are not available to offset the gains.
First, if the outlook for the appreciated stock is quite negative — not merely neutral — that may justify a sale despite the tax consequences. Second, if the appreciated stock has become such a large holding that the portfolio is no longer diversified, some of the position should be sold.
Delay gains from short term to long term. Delay selling shares held less than one year in order to take advantage of lower long-term tax rates.
Harvest losses continuously. Shares sold for a capital loss can be used to offset realized gains. The sale should be used to fund the purchase of a stock with a favorable outlook and with similar characteristics (such as the same sector, etc.), in order to maintain the desired portfolio profile.
While the general idea is well-known, investors seldom take full advantage of loss harvesting. Too often, an investor's idea of loss harvesting is to review the portfolio as the end of the year approaches, looking for suitable candidates to sell. Instead, loss harvesting should be a year-round undertaking.
Use highest-in-first-out (HIFO) tax lot accounting. When a holding in a company has been built up over a period of time, it will consist of a number of tax lots, each one with a different cost basis (or purchase price). When the time comes to reduce the position, capital gains can be minimized by selling first the tax lots with the highest cost basis.
Avoid wash sales. Shares sold for a capital loss cannot be bought back for 31 days if the loss is to be used to offset capital gains.
An additional technique is using losses in one part of the portfolio to offset gains in another part. This is a type of loss harvesting, but of slices of funds or strategies (as distinct from harvesting individual securities within one strategy).
For example, losses on the international portfolio could be harvested to offset gains on, say, a small-cap portfolio. This would need to be implemented in such a way that it doesn't undermine the portfolio's asset allocation. The lesson is to be as holistic as possible about tax management, and not to be narrowly focused on just one part of the portfolio.
While none of these techniques is especially difficult to implement, they do require a dedicated effort; and few investors or asset managers use all of them rigorously.
Earlier, we mentioned indexing. The main way indexing, either through index funds or index ETFs, is tax efficient is deferral of capital gains. In other respects, indexing lags far behind systematic tax management as it gets no benefit from loss harvesting.
The current market environment, with periodic dips and recoveries but lacking a strong overall trend, tends to favor tax-managed strategies because there are many opportunities to harvest losses. For example, while an index fund would have experienced a modest return of just under 1 percent in the first quarter of 2016, a tax-managed fund would have gathered a reserve of losses from the 9 percent mid-quarter dip. Those losses could be put to good use potentially reducing capital gains tax.
Commentary by Paul Goldwhite and Jia Ye. Goldwhite is the director of research at investment-management firm First Quadrant. Ye is a partner and chief investment strategist at First Quadrant.
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