An issue that is overlooked by many people is the tax piece of a portfolio. Very few advisors will discuss an after-tax return because they will have to account for the inefficiencies that we see impact many client’s portfolios.
What are the reasons behind this issue and how can you manage this strategically? There are two solutions which clients should consider to have a more tax-efficient portfolio: investment selection and portfolio construction.
Mutual Fund Investments
According to Statista in 2019, although almost half of U.S. households owned mutual funds, they are notorious for being tax-inefficient (and costly) no matter which way the market is going. The internal trading effects of these vehicles are passed on to the client, even when their investment may be down. Mutual funds were designed to help clients with a smaller account become diversified, which is a good thing; however, the downside is the internal trading inside mutual funds creates tax consequences that are passed on to the investor, regardless of performance.
Investment selection is a vital piece of the total portfolio construction. If you have retirement accounts, you may explore designing your portfolio to where your investments that have a higher tax impact are placed inside retirement accounts so the tax consequences will not affect you every year. Then, you might want to evaluate which type of investment strategy to deploy in your taxable accounts for further diversification and tax efficiencies. Another tip is to research potential capital gains exposure in each fund’s annual report prior to buying the fund for a taxable account. According to U.S. News, “Funds that have had large potential capital gains and have experienced outflows usually have a much higher potential for capital gains distributions.”
When discussing diversification, most people think of stocks, bond, and mutual funds. In reality, true diversification also applies to tax treatment, various time horizons, and portfolio construction that is designed around a client’s vision of their future. If you are curious what that could look like for you, CF Financial would be happy to help.