Skip to content

Six Crucial Factors for Building a Tax-Friendly Portfolio

August 20, 2012
by Jack Reynolds

As the U.S. proceeds toward its much-discussed ‘Fiscal Cliff’ there is the potential for tax increases. This could be due to either a political will to institute them proactively or Congressional discord in which year-end tax rates are allowed to rise automatically to pre-Bush levels. The U.S. is not alone. France has recently taken steps to institute a dramatic income tax increase. As investors, we have very little influence on tax rates, so let’s think about six things we can do to ameliorate their impact.

  1. Asset Location. In building a tax friendly portfolio, one of the first things to consider is the location of your assets. What tax deferral opportunities are available for assets that are inherently tax unfriendly? Please take a look at my very brief video clip in which I address this question.

    You will see how I helped a family that was paying federal, state and city taxes considerably improve the tax-friendliness of their portfolio. In that case, we were able to shift their hedge fund exposures to a deferred compensation plan, which offered a favorable tax outcome. Other tax deferral opportunities include a 401(k), IRA and IRA roll-over. Some investors can place tax-unfriendly assets offshore; however, in the U.S. and other jurisdictions this can only be considered with extensive and highly expert advice.

  2. Asset Allocation. Some asset classes are inherently more tax-friendly than others. In the U.S. for example, income that is generated by municipal bonds is tax-free at the federal level and in the state of issuance. Does that mean that you should only own muni’s issued by the state in which you are domiciled? Probably not, but you should explore this option with your advisers. Other tax-friendly asset classes include private equity and venture capital, which tend to create more tax-favored, long-term capital gains and less tax-unfriendly ordinary income. The tax-friendliness of various asset classes can get subtle and you should discuss them with your advisers.
  3. Manager Structure. Your manager structure can influence the tax-friendliness of your portfolio. A passively managed asset, such as a mutual fund or an exchange traded fund (ETF) that tracks the S&P 500 or other index, can improve the tax-efficiency of your portfolio. A tax-managed, index-tracking mutual fund or separately managed account that harvests tax losses can further improve the tax-friendliness of your portfolio. In an effort to enhance your returns you might add concentrated active managers.
  4. Manager Selection. Pay attention to the degree to which your asset managers buy and sell securities in separately managed accounts and mutual funds. This is known as turnover. For taxable investors, the less taxable turnover the better. Further, the more net long-term capital gains vs. net short-term capital gains the better. Assessing this parameter is equally important for equity and fixed income assets.
  5. Inherently Tax-Unfriendly Investments. It is worth thinking for a moment about tax-inefficient investments that cannot, for whatever reason, be placed in a tax-exempt or tax-deferred vehicle. Should you include tax-challenged investments, such as hedge funds or relatively high turnover strategies, in your fully taxable portfolio? In evaluating this decision you should talk with your investor relations contact about the manager’s or fund’s after-tax investment returns for your specific tax profile. If your contact cannot answer your questions promptly and candidly, then there may be an important message in their lack of effective communication.
  6. Domicile. There are some taxpayers who move to a new jurisdiction in order to achieve a more tax-friendly income and/or estate tax environment. For example, they may move to a different state for six months of the year or a different country entirely. Europeans have done this for years with highly effective results. Matters of changing domicile are highly personal and outside the scope of this article. Suffice it to say that you should consult with fully competent experts and consider your choices with deliberate care and deep reflection. Furthermore, the rules-of-the-road are no joke. You must keep meticulous records, comply with every nuance of the technicalities, and be careful to understand and comply with the spirit of the regulations as well.

As you consider these 6 crucial factors for building a tax-friendly portfolio, it would be wise to address them with your family, investment committee, trustees and/or trusted advisers such as your attorney(s) and CPA(s). Your feedback on this article is valuable to me. Please share your thoughts by dropping me a note or giving me a ring at 617.945.5157. You can also rate this article, share it with a friend or leave comment below. Your comments below will be especially appreciated.