Tax Strategies

Frequent trading can give rise to unnecessary capital gains (and transaction costs) in taxable accounts. If one must scratch a trading itch, I generally recommend doing so within Roth or traditional retirement accounts.

Mutual funds can generate capital gains, even in years when the fund is down. In particular, this creates a situation whereby investors and financial advisers have less control over taxes. 

While many people attribute the tax efficiency of ETFs to low turnover within these funds, the ETF structure actually benefits from an IRS tax blessing that helps minimize capital gains distributions. This gives investors more control over the capital gains that end up on their tax returns. That is, they can decide when to sell an ETF and trigger the capital gains taxes, rather than the fund handing out seemingly random capital gains.

This tax blessing is the primary reason many active portfolio managers are switching from mutual fund structures to ETFs. This 2024 Morningstar article describes this trend, but here is a partial list of active managers who have started making the conversion from mutual funds to ETFs:

• BlackRock
• Dimensional Fund Advisors (DFA)
• Fidelity
• Guinness Atkinson
• J.P. Morgan Asset Management
• Neuberger Berman
• PIMCO
• Putnam
• TCW

While many investors are attracted to investments with higher yields, there are fundamental and tax factors that can make these investments less attractive. For example, some investors apparently operate under the mistaken belief that dividends are free.

However, as discussed in The Dividend Disconnect, the market is smart enough to adjust market prices once dividends are paid. In other words, the overall market acknowledges that a company is worth less after it pays dividends to investors.

Another question investors should ask themselves is why an investment has a higher yield. In most cases, it is not because a company raised its dividend and nobody noticed, raising its dividend yield (i.e., the dividends grew significantly and the stock price languished). Indeed, it is usually because there is some form of distress or risk that has caused the stock price to go down. In other words, higher-yielding investments are typically riskier than comparable investments with lower yields.

In terms of taxes, the issue with higher-yielding investments is that the entire yield is taxable. It is worth noting that there are some exceptions with master limited partnerships, or MLPs, and other investment holding structures. However, for most investments with yields that do not comprise return of capital, the entire yield is taxable, and this is not good from a tax angle.

For the sake of simplicity, consider purchasing $100 worth of stock. If it pays a $5 dividend, the entire dividend is taxable and ends up on your tax return. However, now let’s assume the company did not pay the dividend and the stock price grew to $105 (this is basically economically equivalent).

Selling $5 worth of the stock to generate a synthetic dividend results in a much smaller tax. In this case, the gain before the sale represents less than 5% of the overall position ($5 taxable gain ÷ $105 market value = 4.8%). So, only $0.24 of the $5 sale is capital gain.

On balance, the tax on the yield is more than 20 times bigger than the synthetic dividends taxed as capital gain.

Note: I also do not like MLPs or similar investment structures, as they typically require additional tax reporting (e.g., K-1 or 1065), and can complicate your tax filing.

Depending on one’s tax bracket and current market rates, tax-exempt bonds may be a more favorable option than holding taxable bonds. While this may avoid taxes on the interest, you would effectively pay taxes indirectly via the lower interest rates typically embedded in municipal bonds.

It is worth noting that tax-exempt interest is still included in the calculation of MAGI (e.g., used to determine the tax treatment for Social Security or Medicare surcharges via IRMAA). This is another reason why we generally prefer to utilize asset location (explained below in the Core Tax Strategies section), which would minimize the use of bonds within taxable accounts.

Qualified dividends are those paid by U.S. corporations (and certain qualified foreign corporations) that meet IRS holding period requirements and therefore receive favorable tax treatment. They are taxed at long-term capital gains rates, which are typically lower than ordinary income (e.g., earnings and taxable bond interest). Fortunately, most US dividends are qualified.

Non-qualified dividends, on the other hand, don’t meet these criteria. Dividends from REITs, master limited partnerships (MLPs), and certain money market or bond funds typically fall into this category. Thus, these dividends are taxed at ordinary income tax rates, which can be much higher.

Another helpful strategy for managing capital gains when selling appreciated holdings is to identify and target holdings with a higher cost basis. This practice, typically called tax lot optimization, provides us with some control over the size of the taxable gains we might trigger.

Each time we sell appreciated holdings within taxable accounts, we look at the different costs at which the investment was purchased. For example, even if one purchased a stock decades ago, there are often dividend reinvestments that added to the position, but with a higher cost basis.

Note: This also applies to the tax gain and loss harvesting strategies we discuss below.

It is important to avoid short-term capital gains, if possible, as they are taxed as ordinary income. This relates to many of the other strategies, but is important enough to highlight on its own.

One can intentionally realize a capital loss by selling investments that have declined in value. The purpose of this is to reduce their taxable income. This may reduce capital gains in a given year, allow more flexibility to take capital gains in later years (losses are “carried over”), or possibly offset up to $3,000 per year from ordinary income.

In many cases, we want to harvest these losses, but still maintain the investment or economic exposure. In these cases, we can often replace the investment we sell with a similar investment. However, the IRS imposes something called a wash-sale rule, whereby you cannot simply repurchase the investment after selling it. However, you may be able to purchase a similar, but not “substantially identical,” investment.

We believe tax loss harvesting should be a systematic strategy implemented at least annually, but ideally more frequently or based upon significant market moves.

Tax gain harvesting is a strategy whereby we intentionally sell investments that have appreciated to realize capital gains, but only when taxable income is so low that the capital gains fall into the 0% bracket (yes, capital gains, unlike ordinary income, have a 0% tax bracket).

Realizing gains in this manner can reset the cost basis of one’s investments to a higher level, without triggering taxes. Accordingly, this can potentially reduce future taxable gains.

In some cases, it can make sense to defer capital gains or other types of income. In other cases, it makes more sense to realize the income immediately, or split it up between the current and future years.