Nobody likes to pay taxes, especially on investment portfolios aimed for long-term growth. It obviously follows that to the extent tax liability is reduced, after-tax returns are increased. Tax management does not imply avoiding tax completely but seeks to maximize after-tax returns while maintaining a client’s desired asset class exposure.
Tax-Managed Mutual Funds
In certain asset classes, we can use tax-managed mutual funds to help reduce dividend and capital gain distributions that are paid to fund shareholders through the mutual funds. These funds use tax-management strategies performed by the fund manager. Dimensional Fund Advisors, for example, uses proprietary strategies designed by their team of academic researchers to try and minimize or eliminate short-term gains, harvest capital losses when possible, and minimize dividend yield when appropriate.
Dimensional’s approach to tax management involves:
- Sell highest-cost lots first.
- Avoid short-term gains.
- Avoid realizing gains.
- Harvest and inventory short- and long-term losses.
- Structure the portfolio to manage dividends.
- Patient, price-conscious trading reduces transaction costs.
Cost Basis Evaluation and Reporting
We track the cost basis of managed assets in taxable accounts and consider capital gains implications when trading and managing taxable portfolios. We provide clients with a year-end tax report showing the cost basis of securities sold during the year. We use the “highest cost” method of determining cost to help defer capital gains to future years.
One way to add value to a portfolio in a market decline is to harvest losses while maintaining the portfolio’s proper asset class exposure. We loo for opportunities to generate tax losses for clients who would benefit from them This requires careful trading and planning to make sure that tax rules are followed correctly.