Tax Management

Published On: September 21, 2022

Written by: Ben Atwater and Matt Malick

In life, only death and taxes are certain. But whereas death is unavoidable, you can sometimes minimize taxes.

The concept of after-tax investment returns is difficult to comprehend. Its calculation often depends on the circumstances of the individual investor. And investment companies rarely tout after-tax results.

How do we seek to maximize after-tax returns for our clients?

In brokerage accounts (after-tax portfolios), the most common cause of excess tax liability is excessive trading. Selling appreciated securities results in capital gains. Short-term taxable gains (sold within a year of purchase) are considered ordinary income and long-term gains are federally taxable at anywhere from 0% to 23.8% and in Pennsylvania at 3.07%.

First and foremost, to be tax-efficient, we need to minimize turnover. Therefore, we buy securities for the long-term. Since markets are random and unpredictable in the short-term, we firmly believe excess turnover harms both pre- and post- tax investment returns.

Next, we individually manage client accounts. This is fundamental for us. Our clients’ accounts are not linked to computer trading models or run by third-party portfolio managers who do not know our clients. Therefore, as managers we can pick and choose what to buy and sell in each account. This gives us the ability to make deliberate decisions about tax implications on a case-by-case basis.

Separately Managed Accounts (SMAs) have become popular in our industry because the client’s statement shows individual stocks and/or bonds. It appears customized. However, these portfolios are not really managed for you. Rather, they are standardized computer models that “rebalance,” which in the SMA world can mean frequently trading small numbers of shares to the point of absurdity. All of this unnecessary activity will accumulate capital gains.

Although we hold mutual funds in certain circumstances, we do not advocate for mutual funds. There are many reasons for this, including “capital gains distributions.”

Regardless of a fund’s appreciation or depreciation in any given year, a mutual fund holder is responsible to pay their pro-rata share of gains realized within the fund that calendar year.

As a troubling but all too common example, if you bought a fund in early 2022, the fund would have performed poorly and other shareholders would undoubtedly be heading for the exits. To meet redemptions, the fund manager may sell long-time holdings and realize capital gains, leaving you responsible for the taxes on those gains despite only recently investing in the fund and seeing nothing but declining prices.

Where SMAs and mutual funds create tax events by trading around the edges and distributing gains, they are also disadvantaged by an inability to harvest tax losses based on client-specific circumstances.

Because SMA and mutual fund managers do not know you and do not know what is happening in your life, they cannot proactively realize losses in your account to offset capital gains you experience outside of your managed account.

Tax-loss harvesting is a strategy to lower current federal taxes by deliberately incurring capital losses to offset taxes owed on capital gains. Additionally, tax-loss harvesting can even lower taxes owed on personal income as the tax code allows for up to $3,000 in capital losses to offset ordinary income in a given tax year.

2022 is an ideal year for tax loss harvesting due to the precipitous decline in asset values. We will be diligent in realizing losses in taxable accounts this fall as markets continue to experience uncomfortable amounts of volatility. This does not mean we will take you out of the market. Instead we can realize a loss and replace your market exposure with a similar asset, keeping you invested for when markets rebound.

As long-term investors, we believe excessive turnover adds to portfolio costs and reduces returns, particularly after-tax returns. Additionally, under current tax law, non-qualified assets receive a “step-up in basis” at death. This means the cost basis of your taxable assets are adjusted to their value at your date of death, thereby providing your heirs with securities that no longer have unrealized taxable gains.

In other words, if you are an uber long-term investor, your capital gains “disappear” for your heirs, so death is indeed inevitable, but taxes are not always so.