How deftly do asset managers navigate the US tax code? This article unpacks five important elements of tax-efficient management to help determine whether they’re making the most of tax efficiencies.
When an asset manager says they “manage investments tax efficiently,” what do they mean? Many asset managers claim to use a tax-efficient approach, but there are a wide variety of approaches. The US tax code is complex. Investors may be familiar with the many different ways the sale of a stock can be taxed, but the complexity of the code means there are optimal and suboptimal ways of navigating it.
These five basic tools help investment managers build a comprehensive tax-management strategy:
Defer the realization of gains. A manager may choose to sell an asset with an embedded gain, resulting in a tax obligation. If the manager chooses to hold the security instead, the tax is deferred. This deferral is similar to receiving a zero-interest loan from the government in an amount equal to the liability. As more time passes, the impact of the tax deferral compounds. For investors who anticipate being subject to a lower tax bracket in the future (such as soon-to-be retirees), the value of this loan can be significant. In some cases, the investor can defer payment of the liability indefinitely. For example, capital gains are never recognized when securities are gifted to charity or if their cost basis is stepped up at the taxpayer’s death.
Manage the holding period. Capital gains from the sale of a security are taxed as ordinary income unless the investment is held for longer than 12 months. Long-term capital gains qualify for a tax rate lower than the ordinary rate. Whenever possible, managers should avoid incurring short-term gains.
Harvest losses. Selling an asset whose market price has fallen below its purchase price results in a realized capital loss. These losses are advantageous to taxpayers because they can offset realized capital gains: Short-term losses can offset painful short-term gains, and long-term losses can be applied to friendlier long-term gains. If no gains are available to offset in a given tax year, the investor can carry the loss forward indefinitely. While many investors harvest losses only in December, this strategy is far more valuable if it’s done opportunistically as part of ongoing routine portfolio management.
Avoid wash sales. When an investor repurchases a security within 30 days of its sale, any loss realized can’t be used to shelter capital gains. Tax-efficient managers should take this into account when they’re considering rebuying a recently sold security. It’s important to know these risks exist and to take steps to mitigate them when possible.
The bottom line
Does every asset manager use all these tools? These steps are not always easy to follow, and it’s best to apply them in a coordinated fashion. Managers who can pull all these tactics together can deliver highly tax-efficient investment performance. Managers who don’t could be leaving some tax efficiency on the table.