Thinking about taxes implications for your investments often plays second fiddle in fast moving capital markets and for a large number of investors – pension funds and endowments/foundations the issue is moot given their tax exempt status.
But for many investor be they already wealthy or diligently saving for retirement on their own the issue of taxes is incredibly important. Proper tax management can dramatically alter financial outcomes especially over long periods of time.
Tax management can be complicated and should encompass the full financial and human capital picture and goals of the household or multi-generational family entity. Investments are one aspect of this view but properly evaluating the tax implications of different investment strategies is an important component to the long-term success of an entity’s financial plan.
Taxable investors are not generally able to capture the full potential return of an investment for a number of reasons
- The most obvious and frequently discussed reason are fees and expenses
- The second and often more significant drag on realized long-term strategy returns is due to taxes
While tax structure and rules vary across geographic domiciles (across countries but also by states ) there are generically speaking two types of taxes that subtract from investor returns – taxes on periodic income received (dividends and coupons) and taxes paid upon the sale of a security.
Measuring the tax bite of an investment strategy depends on individual circumstances but it is still useful to look for generalities to assess the likely impact of different strategies on after-tax portfolio returns
We resort to evaluating four different hypothetical strategies using the theory of tax management as outlined in Chincarini and Kim (Journal of Portfolio Management, Fall 2001).
All strategies assume an annual gross return of 8% and a management fee of 1% per year. The strategies vary by the type of trading incurred.
- The advantage of the more tax efficient strategies for creating wealth for investors are clear especially as one extends the holding period. Tax efficient strategies compound at a higher rate because of a smaller proportion of gains paid out as short-term taxes and the deferral of trading events leading to fewer taxable consequences.
- Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy. Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant portion of the potential tax alpha on the table.
Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more sophisticated applications encompass security positions across different asset classes. It is also very important to properly account for the intended final disposition of investment assets.
Finally, we would remiss to not point out that tax policy is not only highly specific to geographic areas (say countries and states) but also subject to significant rule changes over time.
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Eric J. Weigel
Managing Partner, Global Focus Capital LLC
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