A fundamental premise regarding taxes and risk is that, by taxing investment returns, a government shares risk as well as return with the investor. Because the returns on assets held in TDAs and tax-exempt accounts are not currently taxed, investors bear all of the risk associated with returns in these accounts. Even in the case of TDAs in which the government effectively owns Tn of the principal, the variability of an investor’s return in relation to the current after-tax principal value is unaffected by the tax on withdrawals.
Because the returns on assets held in taxable accounts are typically taxed annually in some way, investors bear only a fraction of the risk associated with these assets. Suppose asset returns are taxed entirely as ordinary income at a rate of ti. If the standard deviation of pretax returns is σ, returns are fully taxed at ordinary rates (and all investment losses can be recognized for tax purposes in the year they are incurred), then the standard deviation of after-tax returns for a taxable account is σ(1 − ti). That is, an investor bears only (1 − ti) of the pretax risk.
The account type where assets are held (i.e., the asset location) is important for tax management. From strictly a tax-management standpoint, an investor should locate assets that would be heavily taxed in tax-advantaged accounts and hold more lightly taxed assets in taxable accounts. More lightly taxed can refer to either lower tax rates and/or tax deferral. The value created by this effective tax management of investments is referred to as tax alpha.
Assuming there are limits on how much can be placed in the tax-deferred locations, this generally favors holding bonds in tax-deferred accounts because the bonds produce most of their return from income. In contrast, equities can be held in the taxable accounts. The equity return is typically made up mostly of capital gains rather than dividend income and capital gains can be deferred. By extending the holding period, the TAE can be reduced even in the fully taxable location to improve the equity after-tax return and generate tax alpha.
Generally, the more frequent the trading, the less the ability to defer taxes, increasing tax drag and decreasing after-tax return. Trading behavior can be differentiated as:
- Traders—due to frequent trading, all gains are realized frequently and taxed at a generally higher rate with no deferred tax compounding. Tax alpha is lost.
- Active investors—trade less frequently than traders so that many of their gains are longer term and taxed at lower rates.
- Passive investors—buy and hold equity so that gains are deferred to benefit from pretax compounding and are taxed at lower long-term rates.
- Exempt investors—avoid taxation altogether.
- Asset allocation is more important than asset location.
- Borrowing to optimize both tax alpha and asset allocation is an unusual strategy.
- More frequent trading, even if it increases pretax return, may reduce after-tax return when the additional tax burden is considered (i.e., + pretax alpha may not generate + after-tax alpha).
- Once an appropriate asset allocation is achieved, then it is appropriate to utilize legal methods to maximize after-tax value.
Tax Loss Harvesting
Tax loss harvesting refers to realizing losses to offset realized gains or other taxable income. It reduces the taxes due now but generally does not reduce eventual total taxes. If the benefit is taken now to lower taxes now, it cannot be used in the future and taxes in the future will be higher.
When a tax loss is harvested, the proceeds are typically reinvested, and the reinvested sale proceeds become a new lower cost basis. When the new asset is eventually sold, there is a higher realized gain (or lower loss) for higher tax due (or less tax sheltering) in the future. Taking the loss now means that loss amount is unavailable in the future.
A concept related to tax loss harvesting is using highest-in, first-out (HIFO) tax lot accounting to sell a portion of a position. When positions are accumulated over time, lots are often purchased at different prices. Depending on the tax system, investors may be allowed to sell the highest cost basis lots first, which defers realizing the tax liability associated with lots having a lower cost basis.
Opportunities to create value through tax loss harvesting and HIFO are greater in jurisdictions with high tax rates on capital gains. Studies have shown that a tax loss harvesting program can yield substantial benefits. Although cumulative tax alphas from tax loss harvesting increase over time, the annual tax alpha is largest in the early years and decreases through time as deferred gains are ultimately realized. The complementary strategies of tax loss harvesting and HIFO tax lot accounting have more potential value when securities have relatively high volatility, which creates larger gains and losses with which to work.
A certain amount of trading activity is required to harvest tax losses if a portfolio contains unrealized losses. That is, tax-efficient management of stocks in taxable accounts does not require passive management. It requires passively allowing gains to grow unharvested, but actively realizing losses.
Harvesting losses is not always an optimal strategy. For example, in cases where an investor is currently in a relatively low tax rate environment and will face higher tax rates on gains in a subsequent period, the best strategy may be to defer harvesting losses. Doing so would offset gains that will be taxed relatively lightly compared to subsequent gains if tax rates will increase. Likewise, one might want to liquidate low basis stock (lowest in, first out or LIFO) if the current tax rate is temporarily low.
Holding Period Management
Many tax authorities impose a higher capital gains tax rate on shorter-term versus longer-term holdings. While it is generally desirable to extend the holding period to defer the tax, it is particularly desirable to extend the holding period when it also lowers the tax rate.
The implications of a higher short-term versus lower long-term gains taxation rate are:
- The ratios of ending after-tax value of the patient and rapid trader (1.022 and 1.247 over 1- and 10-year investment horizons) increase in favor of the patient trader:
- At higher rates of return
- Over longer investment horizons
- Rapid trading would require a much higher pretax return to break even on an after-tax basis.
Another dimension of holding period management is the timing of sales in relation to tax year end. If a sale is being considered near the tax year end, make the sale:
- Before year end if it is a loss in order to place the loss in the current tax year and offset gains this year. This will lower taxes this year but raise taxes next year.
- After year end if it is a gain. This will defer the gain and tax until next year’s tax return.
If tax rates are going to change, the analysis could become more complicated. If, for example, tax rates will rise next year, it may become more advantageous to incur the gain now, at the lower rate, than wait.
After-Tax Mean–Variance Optimization
Ideally, the efficient frontier of portfolios should be viewed on an after-tax basis. Because the tax status of an investment depends on the type of account it is in (i.e., its asset location), the same asset could appear on the efficient frontier in both taxable and non-taxable forms.
The mean-variance optimization should optimally allocate assets and determine the optimal asset location for each asset. Accrual equivalent after-tax returns would be substituted for before-tax returns, and risk on an after-tax basis would be substituted for before-tax risk.