Tax-Efficient Investing: It’s Not What You Make, It’s What You Keep

By on October 11, 2017

The beat goes on for the second longest bull market in history.  For the eighth consecutive quarter, the S&P 500 Index notched a positive return.  Small U.S. stocks showed strong gains after a quiet start to the year, up nearly 35% since the beginning of 2016 and reaching all-time highs.  Foreign stocks continued to best their domestic brethren, posting a 21% return year-to-date and reaffirming the importance of staying globally diversified.  Interest rates remain historically low, even after the Federal Reserve’s two rate hikes this year, with a potential third hike on the way in December.

Asset class returns for the quarter and year-to-date were as follows:


Asset Class


Quarter 2017



Barclays U.S. Govt./Credit—Int. Fixed Income



S&P 500 Large U.S. Stock



Russell 2000 Small U.S. Stock



MSCI ACWI ex-USA Foreign Stock



S&P Global REIT Real Estate Securities




Given the substantial appreciation of global equity markets since the dire days of early 2009, many stock-oriented investors now have considerable unrealized gains and little (if any) capital loss carry-forwards remaining.  For taxable accounts (revocable trusts, individual accounts, joint accounts, etc.), the tax classification of a realized gain is important in determining the taxes an investor will pay when assets are sold.  This letter outlines the common types of taxes investors pay on portfolio gains and some of the strategies we use to minimize taxes for our clients.

Long-term capital gains are generally favored over short-term capital gains.  In order for a realized gain (when an asset is sold) to be considered long-term in nature, the asset must have been held for at least one year.  For example, if a share of stock were purchased in 2014 for $70 and then sold this year for $100, the realized gain of $30 would be taxed at the favorable long-term capital gains rate because the stock was held more than one year.  The federal tax rates for long-term gains are 0%, 15%, or 20%, depending on one’s federal income tax bracket.  For those in the highest marginal income tax brackets, an additional 3.8% Medicare surtax may be incurred.  The Medicare surtax brings the highest federal long-term capital gains tax rate to 23.8%, which is still substantially more advantageous than a high earner’s marginal ordinary income tax rate.

Short-term capital gains are taxed at ordinary income rates (the same rates applied to wages and other earned income) and are generally the least favorable for investors.  A short-term capital gain arises when an asset is sold, having been held for less than one year.  In the example above, if a share of stock were purchased at the beginning of 2014 for $70 and sold 10 months later for $100, the taxable gain of $30 would fall into the short-term category and be taxed at ordinary income tax rates, which can be as high as 39.6% at the federal level.

While we do not let taxes drive our investment strategy, we do consider the holding period of each asset before selling in a taxable account since differences between long-term and short-term capital gains rates can be meaningful.  Depending on the individual situation, we may rebalance a portfolio using tax-deferred accounts (e.g., IRAs) to minimize taxable gains.  Our preference to rebalance in tax-deferred accounts will undoubtedly lead to performance disparities between tax-deferred and taxable accounts, but we are primarily focused on the after-tax performance of the overall portfolio.  In order to further reduce our clients’ tax burden, additional strategies such as tax loss harvesting, asset location, and charitable giving techniques may be utilized.

Tax loss harvesting refers to selling an asset at a loss to offset taxes on realized gains (this technique only applies to taxable accounts).  Net realized losses in excess of $3,000 can be “carried forward” indefinitely and used to offset future gains and income.  Even with stellar stock market performance since 2009, opportunities to sell securities at a loss have been plentiful.

For example, at the beginning of 2016, the U.S. stock market declined over 10% during the first six weeks of the year.  This created a short-lived opportunity to harvest losses in taxable accounts.  If an individual stock position were purchased for $5,000 in a taxable account and declined to $4,000, the position could be sold (booking a $1,000 loss for tax purposes) while concurrently buying either a replacement security (i.e., sell Pepsi stock for a loss and replace with Coca-Cola stock) or by buying another investment vehicle to maintain exposure to that specific industry or asset class.  The original stock could then be bought back 31 days later, or the replacement security could remain in the portfolio.  The ultimate goal of tax loss harvesting is to offset current or future gains from the portfolio while maintaining the target asset allocation and the long-term expected return characteristics of the portfolio.  With the recent reduction in custodial transaction fees, this strategy has become even more beneficial.

Asset location is the strategic placement of investment assets (individual stocks, taxable bonds, municipal bonds, REITs, etc.) within a portfolio of taxable, tax-deferred, and non-taxable accounts.  Investments that generate recurring ordinary income (e.g., taxable bonds and REITs) are typically positioned within tax-deferred accounts, such as IRAs.  Investments that produce capital gains and qualified dividends (which are typically taxed at more favorable rates) are generally held in taxable accounts.  A thoughtful asset location strategy attempts to minimize taxes and maximize after-tax returns, but may lead to individual accounts within the portfolio experiencing different returns (i.e., a bond-oriented IRA will likely underperform a stock-oriented Roth IRA over the long-term).  This is why it is important to focus on the performance of the overall portfolio, rather than the performance of individual accounts within the portfolio.

Finally, for those who are charitably inclined, appreciated stocks may be prime candidates for gifting.  Subject to IRS rules and limitations, a security held for more than one year and one day can be gifted to a public charity while the donor may receive a tax deduction.  The amount that can be claimed as a charitable deduction for federal income tax purposes is the fair market value of the security on the date of the gift.  For the donor, gifting an appreciated security is typically superior to giving cash, since the gift of appreciated assets results in a tax deduction and no capital gains tax is paid on the appreciation of the gifted security.  Additionally, those who are over age 70½ and are required to take distributions from IRA accounts can designate some or all of their required minimum distributions (RMD) as a Qualified Charitable Distribution (QCD).  The gifted portion up to $100,000 is excluded from taxable income and can help a donor stay in a lower marginal income tax bracket while accomplishing charitable giving goals.

In addition to the strategies we employ in managing investment portfolios, our financial planning process also heavily emphasizes tax efficiency.  Our financial planning strategies include Roth conversions, timing charitable contributions using donor-advised funds, and other tax saving portfolio distribution techniques.

Improved technology and new portfolio reporting is on the way!

At Dowling & Yahnke, we are always looking for ways to improve our client experience.  Following up on a blog that we released in April entitled, A Peek Behind the Curtain, we announced a partnership with Tamarac that will allow us to offer their reporting technology.  We are in the process of validating the migration of more than 25 years of investment data and creating improved client reports.  Looking forward, Tamarac will soon allow us to deliver powerful portfolio analyses, more flexible reporting, and, most importantly, the freedom for our clients to access their account information at the time and place of their choosing with greater ease and customization.  We look forward to sharing more in the months ahead as we continue to introduce new features aimed at further improving our services.

We appreciate our clients’ trust and confidence in Dowling & Yahnke and invite you to contact us with any questions regarding your finances.


Erik H. Nelson, CFP®, CPWA®, Promoted to Director of Financial...

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