‘Tis the Season…For Taxes

It may not be April, but the holidays can also be an important tax time for investors. As we reach the end of the tax year, your wealth advisor and portfolio management team are busy trying to lessen the tax load on your portfolio.

At Truepoint, because we invest with after-tax returns in mind, we look for opportunities to be tax-efficient whenever possible. There are three main ways in which we are able to minimize the tax drag on your investment portfolio:

• Strategic asset location: sheltering tax-inefficient assets in tax-deferred or tax-exempt accounts.
• Tax-loss harvesting: the strategic capturing of losses in order to offset taxable gains.
• Management of capital gain distributions: monitoring embedded gains and pending distributions of funds to proactively manage tax impact.

Of these strategies, the management of capital gain distributions is often the least familiar to investors. It is also a unique aspect of investing in funds. Capital gain distributions occur when a fund passes through net gains realized from its underlying holdings to shareholders. While the holder of an individual stock has control over the timing of capital gains, this is not always the case for fund investors. This tax implication of investing in funds, however, can be easily managed by well-informed investors. And the benefits of funds over individual securities – broad diversification, economies of scale and uncomplicated rebalancing – are overwhelming. Think how quickly your transaction costs would add up if you tried to individually purchase the thousands of companies you own through your fund holdings!

Remaining mindful of potential fund distributions is important because all investors owning a fund in a taxable account upon distribution of capital gains will incur their pro-rata share of the tax burden, regardless of whether the fund has been owned a decade or bought the day before. The opposite is also true: suppose an investor bought a fund in January, enjoyed its success through the year, and sold just before it paid out a capital gain. While in this scenario the investor would still have to pay capital gains on the sale of the fund, he or she would have avoided the tax implications of the fund’s capital gain distribution.

Fortunately for investors, funds have to declare in advance the date as well as the amount of the capital gain distribution (often scheduled to occur at the end of the calendar year). This gives the investor time to decide whether it is more effective to a) take the capital gain distribution, or b) sell the fund to avoid the distribution. These evaluations are a routine part of our ongoing portfolio management process.

Further increasing the tax-efficiency of our client portfolios is the use of low-turnover funds – that is, funds that trade their holdings infrequently. Not only is this consistent with our “buy, hold and rebalance” investment philosophy, but it limits the taxable activity within the fund. Consequently, annual realized capital gains are often modest because sales of stocks within the fund have been minimal. And it’s important to note that funds don’t always distribute gains; it is also possible that a fund captures a net loss which can be carried forward into future years. This was the case for many funds during the financial crisis, which played a key role in helping to offset gains as the market recovered.

While the holidays may not typically be associated with tax time, we take any opportunity we can to avoid unnecessary taxation and maximize after-tax investment returns. So happy holidays to you, and cheers to tax-efficient investing!