Taxes: How to Help Manage the Inevitable
Doug Walters
Nobody likes to pay taxes, but when it comes to your investments, there are steps you can take to ensure you are not paying any more than you have to.
Contributed by Doug Walters , David Lemire , Max Berkovich , Eh Ka Paw
Taxes are inevitable for successful investors, but they can be managed. This week, we dive into the murky waters of investment taxes and how proper management has the potential to enhance your long-term returns. Taxes are one of our evidence-based guiding principles; we could write volumes on this complex topic, but today, our goal is simply to educate on the importance of tax considerations for portfolio performance.
First, let’s make one thing clear: taxes should not drive investment decisions but instead be one consideration amongst many. While you may be getting advice elsewhere to “minimize capital gains taxes,” a better goal for investors is to figure out how to “maximize your after-tax portfolio returns.” No one wants to pay taxes, but if you’ve invested well, you will likely have to pay taxes on those gains at some point.
What are the potential costs of not taking taxable gains?
- Concentration risk: if you never trim or sell a well-performing stock, your portfolio may have too much exposure to the fate of this one company. That is an unnecessary risk.
- Allocation risk: if you never, for example, trim the high-performing equities in your portfolio, you could end up with too much exposure to stocks, driving your allocation way out of line with your willingness, ability, and need to take risk.
Being willing to take regular gains on your “winners” along the investing journey can help avoid these unintended risks.
But enough about gains. What can we do to better manage that inevitable tax bill? Our toolbelt has two primary tools: asset location and tax-loss harvesting.
Asset location
Numerous tax-advantaged accounts at an investor’s disposal can be utilized to avoid or at least defer a tax bill. Roth IRAs, 401Ks, and 529s are some common examples. Even your health savings account (HSA) may be able to be used to grow your assets in a tax-advantaged way. Knowing which accounts to utilize at each point in your investing journey and which assets to put in each is something a good financial advisor can help you navigate. Vanguard quantifies the benefit at upwards of 60 bps per year1.
Tax-Loss Harvesting
Investment gains can be offset with losses to reduce your tax bill. While nobody hopes for losses, they are an inevitable part of managing a well-diversified portfolio. Some key things to know about tax-loss harvesting:
- This should not be just a year-end exercise. Opportunities to harvest losses come and go; you will want to be ready to sell whenever they rear their ugly heads. So, we monitor weekly.
- Taxes are not avoided altogether. Even if you fully offset all of your gains with losses, you will, as a result, pay higher taxes down the road. So, taxes are more deferred than avoided.
- Not all losses are created equal. The IRS does not allow you to claim a loss on a sale if you immediately buy back the same security. You have to wait over 30 days. If the opportunity for future outperformance outweighs the tax loss benefit, we might hold on to the security rather than take the loss.
- We estimate the potential value of tax-loss harvesting at about 30 bps per year2.
This is just the tip of the iceberg regarding tax-efficient investment management, but hopefully, it makes clear why we have made taxes one of our guiding principles. Successfully navigating these opportunities has the potential for meaningful performance enhancement over time.
Previous articles on our guiding principles can be found here:
- Guiding Overview: Unveiling the Evidence
- Patience: The Foundation of Investing Success
- Diversification: Winning Even if It Doesn’t Feel Like It
- Factors: Systematically Advantage Your Portfolio
- Rebalancing: It Pays to be Opportunistic
- Expenses: A Hidden Drag On Performance
- Taxes: How to Help Manage the Inevitable
- Behavior (upcoming)
1. Based on the 0 to 60bps estimate of the benefit of asset location published in “Putting a value on your value: Quantifying Vanguard’s Advisor’s Alpha,” July 2022
2. Based on our 30bps estimate based on the work in “Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of Tax Loss Harvesting,” Kitces.com, December 3, 2014.
A robust Santa Clause rally!
US large-cap stocks (and small-cap, for that matter) are up over 10% this quarter. Not a bad lead-up to the end of the year!
Headline of the Week
The Pivot
Well, they finally did it. The Fed acquiesced to what markets started pricing in once the 10-Year Treasury hit 5% back in October. The Fed has put three rate cuts on the agenda for 2024, igniting an “everything rally.” Stocks, Bonds, and Gold all moved higher. The Fed is trying to thread a very small needle, evidenced by this sub-headline from the Wall Street Journal, “Officials don’t rule out further hikes while penciling in three rate cuts in 2024.”
Hysteria aside, some rate-cutting makes a lot of sense. 22-year highs for the Fed Funds Rate makes sense when inflation is high and moving higher. However, that is no longer the case, as inflation has receded much faster than initially thought. At this point, rate cuts make sense due to the Fed’s desire to maintain reasonable “real” rates. Simply staying the course while inflation materially declines risks doing more harm than good.
This Pivot is not to say that the Fed and markets are in complete agreement. Focusing on the first part of the convoluted above headline, the Fed is not declaring victory in the inflation battle. Now, the prospect for another rate hike seems challenged, but the timing and actual number of rate cuts have the potential to boost volatility in ’24. Case in point, Friday saw a Fed official partially walk back rate cut talk, prompting some air to leak out of this week’s rally.
The Week Ahead
An Inflation report, a rate decision from Japan, and a final revision to the Gross Domestic Product are on the calendar for the coming week.
Sing it again!
With the interest rate picture in the rearview mirror for now, the personal consumption expenditures (PCE) price index report on Friday can only add more verses to the pivot song.
- The PCE is the Federal Reserve’s preferred inflation measure, and the November inflation reading is expected to make another move down.
- So far, we have worked down from 3.7% in September to 3.5% in October, and hopefully, we will meet or beat the 3.4% that consensus expects in November.
- The Consumer Price Index in Europe is due out on Tuesday and is expected to show inflation moderating to 2.4% year-over-year, matching the earlier flash reading.
The Kabuki Dance
Central Banks in Europe, the United Kingdom, and the US have had their day this past week, but the coming week belongs to Japan.
- Japan’s economy contracted in the third quarter, so few experts believe that the Central Bank President Ueda will alter the negative rate policy.
- However, at some point in the near future, they will have to normalize policy.
- It will be tough for Japan to tighten policy while the rest of the world is pivoting the other way.
- Clarity on rate policy from Ueda will be important, but he will probably continue his kabuki dance and keep the market in suspense for a while longer.
Three and Out
The last and final revision to the 3rd quarter Gross Domestic Product for the US will be released Thursday.
- After a revision higher from 4.9% to 5.2% on the 2nd revision, can we squeeze out another revision higher?
- The last revision was attributed to government spending and increased investment in structures, warehouses, and health care, but consumer spending was a drag.
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on client assets of over $2 billion.
OverviewDisclosures
Strategic Financial Services, Inc. is a SEC-registered investment advisor. The term “registered” does not imply a certain level of skill or training. “Registered” means the company has filed the necessary documentation to maintain registration as an investment advisor with the Securities and Exchange Commission.
The information contained on this site is for informational purposes and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. Every client situation is different. Strategic manages customized portfolios that seek to properly reflect the particular risk and return objectives of each individual client. The discussion of any investments is for illustrative purposes only and there is no assurance that the adviser will make any investments with the same or similar characteristics as any investments presented. The investments identified and described do not represent all of the investments purchased or sold for client accounts. Any representative investments discussed were selected based on a number of factors including recent company news or earnings release. The reader should not assume that an investment identified was or will be profitable. All investments contain risk and may lose value. There is no assurance that any investments identified will remain in client accounts at the time you receive this document.
Some of the material presented is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Strategic Financial Services believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.
No content on this website is intended to provide tax or legal advice. You are advised to seek advice on these matters from separately retained professionals.
All index returns, unless otherwise noted, are presented as price returns and have been obtained from Bloomberg. Indices are unmanaged and cannot be purchased directly by investors.