Tax-sensitive investment management is an ongoing process

We use 4 techniques as part of our approach

Tax-sensitive investment management isn't about using one technique once a year; it's about building a plan that uses multiple tax-sensitive techniques on a continuous basis designed to help you keep more of what you earn.

Some capital losses can be used to an investor's advantage1


Tax-loss harvesting is a way to reduce the taxes associated with capital gains. Let's assume an investor has a long-term capital gain of $5,000 in Investment A, and a long-term capital loss of $4,000 in Investment B. If that investor sells Investment A, they would have a federal capital gains liability of $1,190 (assuming a $23.8% federal tax rate).

However, by selling Investment B and realizing the $4,000 loss during the same tax year the investor sold Investment A, they can use that loss to partially offset the gain in Investment A. By doing this, they net long-term capital gain from $5,000 to $1,000, which would reduce their tax liability from $1,190 to $238.

Even when the market's up, there may still be volatility and certain asset classes or categories that are down. This means that there are potential opportunities to harvest losses to offset gains. Knowing when to act can dramatically impact an investor's plan.

When investments held in an account have lost value, we may sell those investments, thereby "realizing" the loss. That loss can be used to offset ordinary income (up to $3,000 per year). If an investor has losses of more than $3,000 in any given year, that investor may be able to carry those losses forward and use them to offset gains in a future year.

Understanding the optimal time to realize gains and losses can often mean monitoring up to hundreds of different tax lots on a daily basis. Our investment managers are continuously on the lookout for appropriate opportunities for each investor in light of their particular situation.

Losses today may help reduce capital gains taxes in the future2


In this example, the investor used a $10,000 net loss in 2008 by utilizing the carryforward tax-loss strategy and avoided paying capital gains for the next 4 years. It wasn't until 2012 that gains resulted in a tax liability. This is important because compounding helps to accelerate wealth building, so it's typically a good strategy to defer paying taxes for as long as possible.

Our sophisticated, analytical approach helps us better identify when to realize the gains and losses that can help offset an investor's tax obligations. This powerful tax-sensitive investment strategy can have both an immediate and ongoing value to an investor.

How long an investment is held matters


Take a hypothetical investment with a pre-tax gain of $10,000. In this case, the potential tax savings available as the result of waiting for a year are $1,700, assuming the investor is in the top marginal tax bracket. $10,000 (40.8%–23.8%) = $1,700.

The amount of time until long-term status is reached is important. Consider a $100,000 investment made 365 days ago that is now worth $110,000 (a gain of 10%). If the security were sold today, the tax bill would be $10,000 x 40.8% = $4,080, with an after-tax return of 5.92%. However, assuming the value has held steady, by waiting one additional day, the tax liability drops to $2,380, and the return increases to 7.62%.3

Investment gains are taxed at different rates depending on the length of time an investor holds an investment. Holding an investment longer can mean a lower tax rate. There are a number of factors to consider in determining the right time to realize a gain, including expected future return on the investment, individual tax rate, how long the investment must be held to get a more favorable tax rate, and how the holdings impact an investor's overall risk level.

We track every investment in an investor's portfolio and consider all these factors simultaneously across a large number of positions and tax lots. This helps us determine when it makes sense to realize gains in order to potentially reduce the impact of taxes across the portfolio.

Mutual fund distributions present an opportunity for tax-sensitive investment management


Each account will hold shares of different funds that pay out distributions on different dates. Account owners may also need to pay taxes on some of these distributions, which could add to their tax bill.

When mutual funds pay distributions to their shareholders, due to either investment gains realized through trading or from dividends, those distributions become taxable events. While it's possible for investors to manage distributions, it can be a very time consuming and complex process. Not only does the investor have to continually monitor the markets and develop a clear picture of each fund's potential future performance, they'll need to understand how and when each fund may pay out distributions and how those distributions may be taxed.

We use tax-sensitive investment strategies to monitor the funds held in each account in an effort to stay on top of the amount and timing of when those distributions will be paid out. We'll also work to avoid certain distributions where appropriate. For example, in some cases, it may make sense to move investments out of certain funds into other funds that pay lower distributions. This will depend on a range of factors, including the amount of time an investor has owned shares in the fund, the investor's current tax bracket, performance expectations, any unrealized gains they may have, and distributions paid by other funds in which the investor owns shares.

Depending on an investor's tax rate, our ability to avoid distributions could significantly reduce the taxes the investor may pay. With ordinary income tax rates as high as 39.6%3 and long-term capital gains taxed at a maximum rate of 20%,3 reducing distributions could make a big difference.

Tax-exempt securities may provide higher after-tax returns than equivalent taxable securities


There are different types of bond funds in the bond fund universe, including taxable, national municipal, and state municipal. When we select bond funds for an account, we'll consider a number of different factors to help us determine the appropriate mix of those funds in an investor's account in an effort to potentially enhance after-tax returns.

When appropriate, we may invest in municipal bond funds in pursuit of higher after-tax returns. The interest on these bond funds is generally exempt from federal taxes and in some cases state and local taxes, depending on the fund and an account owner's state of residence.

Because the interest income paid out by these funds is exempt from federal taxes, their after-tax returns could actually be higher than taxable bond funds. That means that a municipal bond fund with the same coupon as a taxable bond fund could provide higher after-tax returns.

For example, among investors in the highest federal tax bracket, a 3% municipal bond yield can produce a tax-equivalent yield comparable to that of a taxable bond with a 5.07% yield.4

Our investment management team will determine whether municipal bond funds are appropriate for your situation. To do this, we'll consider a range of factors such as your individual tax rate, state of residence, and the characteristics of the individual state municipal market, including credit rating, bond issuance, volatility, and liquidity.