October 13, 2022

Five Strategies for Building a Tax-Efficient Portfolio

By Alexander Sterba, Financial Advisor

Five Strategies for Building a Tax-Efficient Portfolio

As we approach tax deadlines, there’s one common refrain we hear from our friends at Marcum LLP: “We see tax returns with massive amounts of capital gains. Is this normal? Is there an easy and effective way to reduce this amount?”

Focusing specifically on the investment portfolio, there are certain strategies to consider. In fact, “tax alpha” is a relatively new term that measures portfolio dollars saved with tax-efficient strategies. Controlling tax alpha is a way to add value and return without ever changing the risk tolerance or nature of your investments.

When faced with a large capital gains bill, it is wise to audit your investment portfolio and deploy the following strategies to mitigate your tax burden.

Capital Gains Strategies

Choose ETFs Over Actively Managed Mutual Funds

Exchange-traded funds (ETFs) are one of the most tax-efficient investment vehicles. Due to the nature of their creation/redemption process, ETFs (unlike many mutual funds) typically do not pay out large capital gains to shareholders at the end of the year. In addition, actively managed mutual funds have higher variability in redemptions, leading to larger tax bills.  Before end of the year capital gains taxes are paid out, it may make sense to swap into an ETF.

Tax Loss Harvesting

Tax loss harvesting refers to the process of selling an asset at a loss, then immediately purchasing a similar asset to lock in the loss on paper. This allows investors to create tax savings without materially changing their long-term strategy. The assumption is that your new security will perform in line with the one you sold. This allows for a similar investment rate of return. However, the locked-in capital loss can add tax alpha. 

At most, capital tax losses allow you to write off $3,000 of ordinary income per year. In addition, capital losses offset capital gains in the year they are incurred. If there are more losses than gains in a given year, these losses can be carried forward indefinitely. It is important to know the rules associated with this strategy. Wash sale rules dictate that you cannot buy or sell securities for tax benefits 30 days before or after the initial purchase. In addition, the definition of a “similar asset” should be well reasoned before executing a tax loss harvest transaction.

Direct Indexing

In this approach, individual securities are purchased to track a broad market index. For example, a direct index account of the S&P 500 would have a similar makeup and weighting to the 500 companies within that index at a given time. This allows for greater tax loss harvesting flexibility while staying within the parameters of the index. One downside to this approach is that managing a direct index requires a starting account balance as high as $250,000, depending on the index being tracked. However, this concept has gotten more popular and can be deployed for no additional fees, making it both low cost and tax efficient.

Asset Location

Asset location involves placing certain investments into a specific account structure. There are three broad account types: tax-deferred (IRA, 401(k)), taxable (brokerage, savings), and tax-exempt (Roth IRA, HSA). Certain investments are best suited to different account types. 

Bonds that pay interest accrue taxes on that interest at ordinary income rates when not held in a tax-advantaged account. Therefore, bonds may be better suited to an IRA. Higher growth assets, such as small cap-equities or REITs, are normally best suited for a Roth IRA. Since all withdrawals from a traditional IRA are taxed at an individual’s ordinary income tax rate, you can avoid paying the higher income tax on those gains. The more capital gains that accrue in a Roth IRA as opposed to a traditional IRA, the more tax-efficient the portfolio will be.

Also, when you factor in required minimum distributions (RMDs), it may make sense to have lower growth assets in an IRA to keep taxable distributions under control in retirement. There are many layers to asset location and many ways to invest and withdraw money when the time comes. Positioning assets correctly can help ease your tax burden now — but it can also help when it is time to withdraw assets for retirement.  Finally, correct asset location is beneficial when you’re planning your estate thanks to a step-up in basis.

Build a Buffer

Large capital gains bills often come due when there is an unexpected need for cash or liquidity. Medical expenses, home improvements, weddings, and unforeseen events can force a sale of assets. Having an emergency fund or a cash buffer can help you avoid selling assets that may have a large gain. Cash and equivalents give you time and flexibility to manage sales and rebalance assets to spread taxable gains over different calendar years. 

To fully take advantage of tax alpha, you must consider all the prior strategies when constructing a portfolio. If they are not baked into your process, you could be funneling more dollars than necessary into the IRS’s pocket. Tax-efficient investing is core pillar of the Marcum Wealth financial planning and investment process. As always, feel free to reach out to anyone at Marcum Wealth to discuss tax and investment strategies in more detail.

Important Disclosure Information

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Marcum Wealth, or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Marcum Wealth. Please remember to contact Marcum Wealth, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Marcum Wealth is neither a law Firm, nor a certified public accounting Firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Marcum Wealth’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request. Please advise us if you have not been receiving account statements (at least quarterly) from the account custodian.