The Best Way to Create a Tax Efficient Portfolio

In our role as financial and investment advisors at Glassman Wealth Services, we are often asked what effect taxes and fees have on a portfolio. This is especially true of new clients who may not have been paying attention to those expenses in their portfolio. The answer is that they can quickly add up.

It’s not just do-it-yourself investors, but even some financial advisors ignore those expenses, placing too much effort into how to best structure a portfolio and not enough into low hanging opportunities such as keeping taxes and fees low.

Frankly speaking, a tax efficient portfolio can be tricky for someone who is not very knowledgeable about investments. But if you are investing on your own or with an advisor, here’s what’s important to know about the best way to create a tax efficient portfolio.

What is Tax Efficiency?

Portfolio tax efficiency is simply how much of the gains generated by your portfolio you keep after accounting for fees and taxes. The greater the tax efficiency, the more of your gains you keep. Think of this as similar to your paycheck; it’s just like the difference between your gross earnings (pretax) and net earnings (after taxes).

Using US stocks as an example, one way to get exposure to the broad equity market is from a low cost S&P 500 index mutual fund. While low fees are important, it’s the tax efficiency of the index that has the greater impact on after-tax returns. In the S&P 500 index, turnover is very low, averaging less than 5% per year. In other words, about 5% of the total value of S&P 500 companies is removed or added yearly in the index (think getting rid of of J.C. Penney and adding Facebook in 2013).

This is in stark contrast to how most money managers invest. On average, US equity managers turnover their complete portfolio once every two years. It is therefore rare for any company to stay in the portfolio for a long period of time, and it’s this buying and selling of securities that create taxable gains within the portfolio.

There are several steps you can take to improve to improve the tax efficiency of your portfolio and I have outlined a few below:

1. Indexing for Efficiency

Would you rather keep 11.3% or 9.6%? That’s the after tax difference between the Vanguard S&P 500 index and the average US large cap equity fund for the past 3 years. What accounts for the difference is two things – fees and tax efficiency. The annual index fund fee is 0.17%, whereas the US equity manager fee 1.03%. Bigger still, the turnover of stocks in active manager portfolios was 10 times greater than that of the index. All that trading can erode returns by generating taxable gains.

Important Note: I’m not advocating that every investment in a portfolio should be an index fund. We certainly use managed funds in many areas of our portfolios where it makes sense. Instead I’m suggesting that in certain asset categories you might consider indexing for efficiency and using active managers for other segments of the markets.

2. Select Tax Efficient Managers

For those places where it makes sense to use active management, like global equities or emerging market portfolios, seek out the following attributes to improve tax efficiency. Choose a manager with low turnover, longer holding periods and low fees. The lower the turnover, the greater the tax efficiency. The lower the fees, the less annual drag on performance.

Morningstar.com offers free information showing fees, turnover percentages and tax cost efficiency for every mutual fund manager. Even better, they calculate tax-adjusted returns showing just how much of the returns, net of taxes, you would have kept historically.

3. Consider Your Portfolio Structure

Your portfolio should have a strategic framework, think buy and hold, with reasonable bounds on how much you expect to own in stocks, bonds and other assets. Then, a deliberate decision should be made regarding whether to index certain investments and where to hold these investments. Generally, the most tax efficient investment should be in taxable accounts and the least tax efficient in tax deferred accounts (401k, IRA rollover accounts, etc.). We explain the benefits of asset location in The Best Way to Minimize Taxes with Asset Location.

Having a plan for the portfolio structure will improve the tax efficiency by better (low cost, low turnover) manager selection and improved asset location.

4. Harvest Tax Losses

Lastly, harvesting tax losses through active tax management can improve the efficiency of your portfolio.

Periodically the markets decline in concert as they did in 2002 and again in 2008. Sometimes, we have markets where only certain segments of the market decline, like emerging markets in 2013. Years like 2002, 2008 and even 2013 can provide investors with opportunities to harvest tax losses.

The idea is simple. If you have an investment with a tax loss, we recommend that you sell it, capture the tax loss and move into an investment with similar characteristics. This can be accomplished with a mutual fund for mutual fund swap, a stock into ETF swap or vice versa. This doesn’t change the structure of investments in the portfolio but does capture losses to offset future gains in the portfolio when markets recover.

Putting it All Together

I hope this gives you a better understanding of why you should pay attention to the taxes and fees in your portfolio and what you can do to keep more of those hard-won gains. Let us know if you found this helpful by contacting us here.