Tax Efficient Investing Strategies
D.R. Harris & Co. uses a number of strategies to help minimize the impact of taxes on your investment portfolio.
Direct Company Holdings
Unlike many advisors, for tax reasons, D.R. Harris & Co. frequently recommends direct stock holdings and municipal bonds and US Treasury Bills or Notes in taxable accounts. Municipal bonds generally have the lowest tax burden because they are typically exempt from most Federal taxes even if a state other than your own is issuing the bonds. The interest on US Treasury Bills and Notes is generally exempt from state income taxes. Direct holdings of U.S. stocks also receive highly favorable tax treatment from the IRS because qualified dividends are taxed at a lower rates and long term capital gains taxes on stocks are similarly taxed at low rates. Additionally our firm may use a lot of US Government Treasury Inflation Protected Securities whose interest may be exempt from state income tax.
Mutual funds may create unwanted taxable events even when your shares don't appreciate. For example, if you bought a mutual fund in 2011 that appreciated 30% between 2009 and 2010, you would be liable to pay taxes on those capital gains when distributed even though your personal shares in the fund did not appreciate because the capital gains are distributed to all the shareholders regardless of when they bought the fund.
Index funds must change their holdings whenever an underlying index changes and this creates a taxable event for you even if you don't sell your shares. For example, the Vanguard Total Stock Market fund may make up to or over 100 securities transactions a year in some years, half of which may create taxable events.
When you own assets directly you have control over when you will experience taxable events. As a result, using direct asset holdings and highly tax efficient vehicles in a taxable account can create the best potential for long term growth after accounting for taxes.
Low Turnover Index Funds and Mutual Funds
We don’t always recommend exclusive use of direct asset holdings (although that is the cheapest way to own an asset with no extra carrying costs). We recommend using index funds or mutual funds to help add diversification into certain assets especially when you are buying a small amount or to gain access to a market that is difficult to access directly. For example, we may recommend diversifying into a bond fund because we believe that it is better to own lots of bonds than just a few. Similarly, mutual funds and index funds can provide better access to foreign assets by buying from their country’s stock and bond markets directly instead of choosing amongst the relatively few foreign compnanies that list their shares on the New York Stock Exchange or Nasdaq. Most of the time when we use mutual funds in taxable accounts, we seek to utilize funds that have lower investment turnover and less frequent distributed capital gains thus saving you from the burden of paying more taxes.
Tax Optimized Withdrawals
If you do need to make a large withdrawal from your taxable account to put a down payment on a house, pay for education, or make another large transaction, we will recommend selling assets in a way that balances the need to limit the tax burden caused by the withdrawal while trying not to sell your very best assets that have the best potential for long term growth. In this way we help you reduce your taxes in the short term while not stunting the growth of your portfolio in the long term.
Tax Aware Asset Allocation
Depending on the tax status of your account, we recommend different investments for your portfolio. The US Tax Code does not treat all investment assets equally and gives some assets preferential tax treatment and others are exposed to higher taxes on distributions. We pay attention to the "tax drag" or investments in recommending where to place certain investments. While some investments may seem to have a relatively small tax drag of just 3% a year, in a decade 30% of those assets will have been exposed to taxes in a taxable account.
Certain types of investments naturally have a high turnover and others naturally have low turnover. We may recommend higher turnover assets in retirement accounts where they are shielded from taxes and lower turnover assets for taxable accounts where they are fully exposed to taxes every time they are replaced. The best assets for taxable accounts may have lower turnover than index funds and we may recommend those types of investments in taxable accounts.
Tax Loss Harvesting
Tax loss harvesting is when you sell an asset in a taxable account for a loss and buy it back 32 days later. This enables you to hold virtually the same portfolio over time and 1) reduce your taxes owed on your investment gains this year 2) reduce your taxes owed on investment gains in the future or 3) use it to reduce your "earned income" or how much you earned from your job for tax purposes by up to $3,000 a year.
Tax loss harvesting is best when used in moderation but it is easy to go overboard. In certain environments nearly all assets lose value and you can benefit from tax loss harvesting them. But in most environments the investments that generate frequent tax loss harvests are the worst investments that make your money grow the least over time. The best companies, those that grow the most over time, may not even drop beneath the price you paid for them and therefore don't produce any opportunity for tax loss harvesting.
Many investors struggle with how to use the tax rules to their benefit without being counterproductive and letting the tail wag the dog. As a general rule, we believe that lowering the quality of your investments will hurt you more than any benefits you can make back from tax loss harvesting.