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The case for tax aware investing
SUMMARY
Taxes on portfolio income and gains can have a significant impact on investors’ wealth accumulation over time. However, there are ways to lower taxes paid toward the least required by law.
Newly arrived visitors to the US are often perplexed when a server first presents them with the check at the end of a restaurant meal.
The total cost typically works out rather greater than the sum of the prices they saw on the menu.
This phenomenon, of course, results from the US quirk of displaying prices before sales tax. (There’s also moral pressure to leave a large tip, but that’s another story.)
A similar principle applies to investment portfolios. The return figure we most commonly see may not be that close to the return we get.
Again, tax is a major reason for this.
Investments held outside of tax-advantaged vehicles are typically liable to levies on income received and any capital gains.
As such, an investment’s headline performance between purchase and sale is often much larger than what the investor ends up with, i.e., after tax is accounted for.
Especially over longer periods, the effect of tax upon a portfolio’s returns can be significant.
So, any investor who treats the top-line return quoted in financial media reports or their account statements as their “outcome” may find themselves rather less well off in the future than they were counting on.
Unlike with a meal in a US diner, bistro or upscale eatery, though, there may be potential to mitigate taxes on investment portfolios.
What is tax aware investing?
Tax aware investing is an approach that seeks to reduce taxes payable on returns toward the least required by law.
If successful, this approach can potentially boost after-tax returns.
The additional return that may be achieved is called “tax alpha.”
This approach is not about changing a portfolio’s asset allocation or the amount of risk taken.
Instead, tax aware investing may use several strategies in combination to pursue higher after-tax returns.
What are some tax aware investment strategies?
Figure 1 summarizes some of the measures that tax aware investors often take as they seek tax alpha.
We consider some of them in the section that follows.
Strategy |
Description |
Tax deferral |
In a two-tiered tax system, postponing an investment decision and waiting to take advantage of lower long-term tax rates on capital gains |
Tax loss harvesting |
Selling securities at a loss to offset gains in an investor’s portfolio or outside of the managed portfolio |
Managing wash sale rules |
Avoiding the trigger of wash sales due to frequent trading of the same or similar security |
Loss carryovers |
Applying losses harvested in one year to be used in the following or future years |
Coordination across outside investments |
Coordinating losses outside of a client’s managed portfolio can help contribute to achieving a client’s overall investment objectives and expedite implementation of an investment strategy |
Source: Citi Investment Management, as of 12 Sep 2024.
Gains deferral
According to the adage, good things come to those who wait.
For investors, waiting for gains to accumulate over time may potentially result in a good thing when it comes to after-tax returns.
In other words, taxes get deferred until further into the future.
For gains on positions held for less than a year in the US, the capital gains rate can be much higher than that on gains on positions held for more than a year, depending on an individual’s circumstances.
Delaying sales until after one year may make sense, therefore.
Even after a year, deferring sale into the future can also have potential benefits.
If the asset continues to increase in value over whatever period, it will result in a larger gain to be taxed upon sale.
This may prove especially worthwhile in cases where an investor is likely to be in a lower tax bracket in the future or if rates may have been lowered across the board.
Of course, this cuts both ways. Gains can even become losses due to holding longer into the future.
And both individual tax circumstances and general tax rates can change unfavorably.
Continuous tax loss harvesting
Traditionally, we think of a harvest as a process of reaping the rewards of growth, be it crops or whatever else.
However, sometimes it can be advantageous to deploy the thresher and bring in what has gone against us.
Tax loss harvesting is about crystallizing losses by selling up investments that have fallen in value since purchase.
The resulting loss may then be used on a tax return to offset gains in other parts of a portfolio.
This can happen either in the same tax year or in future years.
Some investors only engage in tax loss harvesting strategies at the end of the year when taxable gains are typically calculated.
However, this activity can take place at any point during the year when possibilities present themselves.
This strategy is not without pitfalls.
It requires adherence to strict tax rules and rigorous record keeping of gains and losses.
Significant sales can also see a portfolio drift away from the investor’s long-term investment plan.
If sales occur during a market selloff, the investor may miss out on the bounceback recovery in the price once the correction or bear market ends, especially if any replacement purchase underperforms.
Wash sale monitoring
One of the hazards of tax loss harvesting strategies is falling foul of wash sale rules.
A wash sale is where an investor sells a security and repurchases the same security or one that is “substantially identical” either thirty days before or after the sale.
A substantially identical security could include other claims on ownership of the same company or a strategy tracking the same fund from two different providers.
As a result, it is vital to monitor closely to avoid inadvertently triggering wash sale rules.
This can be complex, especially with large portfolios or where many accounts are held.
Which market conditions are best for tax loss harvesting?
Individual equities can suffer losses whether broader markets are rising or falling.
In 2022, for example, the S&P 500 Index ended the year down 18.1%, with 72% of stocks registering a negative return.
In contrast, 2023 saw the same index recover, rising 21.9%. Despite this, 36% of stocks in the index had negative returns.
So, while there may be more scope for tax loss harvesting during down-markets, this approach is also possible amid positive conditions.
How effective are tax aware investment strategies?
Various academic studies have demonstrated the potential benefits of tax aware investment strategies.
For example, An Empirical Evaluation of Tax-Loss Harvesting Alpha (2020)1, cited findings that a tax aware portfolio could have potentially outperformed a similar portfolio that was not tax aware by 27% over a 25-year period.
Theory and experience may support the case for this approach.