- Tax-smart investing1 starts with a broad investment mix that's based on an individual's goals, time frame, and financial situation.
- Layering tax-smart techniques over an investment mix may help boost returns as the investor may pay less in taxes, keeping more of their money invested.
- At Fidelity, tax-smart investment management is only available in discretionary managed accounts.
What is tax-smart investing?
The old maxim, "buy low, sell high" misses an important part of the equation: taxes. The value of extra after-tax returns created by tax-smart investing is called tax alpha. When an investor avoids or defers taxes because of tax-smart investment management, that money can stay invested and has the potential to grow. And when those tax savings are compounded year after year, they can have a significant impact on the total value of a portfolio.
Tax-smart investment management starts with an investment mix that's right for the investor. Tax-smart investment techniques layered on top of that foundation are designed to help keep the tax bill in check, when possible, and keep more of the investor's money potentially growing.
DIY investors can do this for themselves but the attention to detail that's required can make it an area where professionals can really help out.
Why does it matter to you?
If an investor is paying too much in taxes, they could be missing out on extra growth and compounding. The goal behind tax-smart investment management is simply to try to enhance after-tax returns for a client’s appropriate level of risk.
Morningstar estimates investors gave up an average of 1% to 2% of return per year to taxes for the 92 years through 2019.2 Let's say a portfolio could earn 8% per year instead of 6%. That extra return of 2% per year on a hypothetical portfolio of $100,000 could result in more than an additional $1 million after 40 years.
These are the techniques that Fidelity uses
Selling all of an investor's existing investments and buying new ones may trigger a large tax bill so it makes sense to integrate their current eligible investments with a tax-efficient strategy.
At Fidelity, the investment team will do what they can to transition to the desired investment mix as tax-efficiently as possible.
Manage short-term gains
Considering the differences between short- and long-term capital gains tax rates when considering selling an investment can help avoid paying higher tax rates.
At Fidelity, our tax-aware investment managers try to take advantage of deferring capital gains, but they also carefully consider the risk and return expectations for each investment before trading.
Harvest tax losses
When an investment is sold for less than its purchase price, the loss can be used to offset realized capital gains and, potentially, a small portion of taxable income.
At Fidelity, tax-loss harvesting happens throughout the year in our tax-smart managed accounts, not just at year-end, to look for more opportunities to help our investors reduce taxes or offset gains.
Manage exposure to distributions
Mutual funds distribute earnings from interest, dividends, and capital gains every year. There are ways to potentially avoid distributions and the tax liability that comes with them, but the best course of action depends on the situation and strategy.
At Fidelity, our research team monitors capital gains distributions from mutual funds throughout the year and incorporates the information into their investment process for tax-smart managed accounts.
Take tax-smart withdrawals
When an investor wants to withdraw money from a taxable account, choosing the investments to sell can significantly impact the investment mix and the investor's tax bill. Selling investments to fund a withdrawal can also impact the level of risk in the account and potentially reduce the value.
When it's time for an investor to withdraw money from their account, whether it's to support an ongoing income need or for a one-time withdrawal, Fidelity uses a variety of tax-smart investing techniques designed to help reduce the potential tax impact of making those withdrawals on the client's investments and ensure their investments remain aligned with their goals.
Investing in municipal bonds and ETFs
Tax treatment varies among investment types. For example, income from municipal bonds is typically exempt from federal taxes, and in some cases, from state taxes as well.
At Fidelity, our tax-aware investment managers incorporate municipal bond mutual funds or exchange-traded funds into managed portfolios for clients when it's appropriate.