Our investment philosophy and portfolio management process are anchored by three foundational tenets – Discipline, Tax-Efficiency, and Cost Control. Experience tells us that we cannot control the daily movements of the market, but we can control these three tenets and, by doing so, strive to have a positive impact on your portfolio. With each investment change we contemplate, we ask ourselves: How will this decision impact our investment philosophy, and are we staying true to our foundational tenets?
We welcome you to our blog on Tax Efficiency, the third of a three-part series in which we expand on our investment philosophy and its relevance to you. See our prior weeks’ blogs on Cost Control and Discipline.
Understanding Tax Efficiency and Liability
What does “Tax Efficient” mean? It simply refers to the attempt to minimize tax liability when making decisions about the portfolio. It is quite common for individuals to spend time thinking about what they own in their portfolio, focusing mainly on the risk and return of each holding and the changing price of each. What many do not consider is, even though prices may rise, the growth does not belong entirely to the account owner. How can this be? Well, it’s often the case that in our great country, we face the requirement to pay taxes, and Uncle Sam stands ready to take his cut when money is made in the portfolio. It is entirely possible that a portfolio could be well-structured from an investment perspective, but completely miss the mark by not minimizing taxes. Minimizing taxes sounds good, right? So how do we go about achieving this efficiency?
Our Tax Efficient Process
There are two main ways that our team strives to reduce taxes owed. First, our professionals use a method widely known as “asset location” to save on taxes. Asset location means that we will look across various accounts to find which one is best suited to hold each type of investment. An example illustrates this idea: If we decide that 20% of a portfolio should be in bonds, and our client has three different accounts (a taxable account, a traditional IRA, and a Roth IRA) should each of the three accounts hold 20% of bonds? In our opinion, no. Generally, because many bonds pay out ordinary income which is often taxed at a higher rate than long term capital gains, we would likely place those bonds in a traditional IRA where our client would have a tax shield for the interest income received. We would prefer to concentrate those bonds in the traditional IRA only and likely own no bonds whatsoever in the Roth IRA nor the taxable account. This gets tricky to monitor as owning 20% of the portfolio in bonds means that more than 20% of the traditional IRA will be in bonds to achieve the whole portfolio’s target. We could set up a similar example using stocks rather than bonds, but sticking with this example, it’s clear that stocks would be underweight in the traditional IRA and more concentrated in the taxable and Roth accounts. While the management of this approach is more complex than simply setting up each account in a portfolio with identical weights, we believe it’s worth the effort.
In addition to asset location, our investment committee focuses on selecting investment vehicles that are generally tax efficient in nature. Did you know there are some investment vehicles that are more tax efficient than others? This is certainly the case. Two investors may try to gain access in their taxable account to the same area of the market and pay quite different taxes. An actively managed mutual fund may have higher turnover than an index fund, making the index fund more attractive from a tax perspective. Additionally, Exchange Traded Funds (ETFs) may have additional tax efficient benefits related to their structure which allows some rebalancing within the fund without causing a taxable event. This structure differs from the traditional mutual fund which has to pay taxes on gains even from rebalancing trades. Our investment committee pays close attention to these details in order to create a tax picture that attempts to minimize taxes owed. While operating within the tax code, our goal for tax efficiency is to keep as much in our client’s pocket as possible.
Understanding the importance of tax efficiency in your portfolio will help you on your way to becoming a savvy steward of your investments. The fee-only financial planning services of Payne Wealth Partners and Keystone Financial Consulting are designed to provide clarity, confidence, and peace of mind through a planning-centric solution. Let’s start a conversation about wealth management that’s focused on what’s most important to you.
As always, we welcome your questions and comments concerning your investments, and we certainly appreciate the trust and confidence you have placed in us. Thank you for your business!
Posted: May 30, 2016
Authored by: Bethany Muensterman, CFA
Direct Phone: 812-602-6307
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