Tax Planning A primary goal of Garde Capital is to maximize after-tax risk-adjusted returns. In being able to do so, it's important to clarify that what clients pay Garde Capital for is Investment Advisory services, not tax advice. The practice of tax is done by Certified Public Accountants. Although Garde Capital does directly employ several CPA's, we do so as an ancillary service to our primary expertise, investments. But as it pertains to investments, we do believe that being fluent in the area of tax and closely working with your tax-advisor to bring together both tax and investment expertise is very beneficial for you, the client. We attempt to do this with every relationship we have. In terms of investment industry norms, we've generally found that a problem with large investment firms is homogenized investment offerings that are not tax friendly, and a problem with small firms is that they can lack expertise. At Garde, we look to directly address taxes in every portfolio, and apply the expertise needed for clients to get the most out of their unique tax situation. The Importance of Tax Planning To illustrate the importance of taxes, we start with an observation that the difference between no taxes and immediate payment of all taxes at the highest marginal rate is significant. See actual spreadsheet here. Although getting to the no tax portfolio is not likely, it at least gives us an idea of the range of possibilities. Tools for Getting Closer to the No Tax Portfolio An easy way to get your mind around investment taxes is to consider taxes in two dimensions: Types of asset ownership (Retirement Plans, IRA's, Roth's, Joint, Trust, etc.) Tax treatment and strategies related to the different types of investments (capital gains, dividends, interest income, etc.) Types of Asset Ownership Unfortunately when accumulating serious wealth, the tools available for tax deferral, like retirement plans, are relatively minimal compared to significant income and assets, (e.g. $50,000 maximum for defined contribution plans.) But even so, the first thing we want all clients to do is maximize these low level benefits. And although we want to maximize the benefits of ownership types, we don't at any cost. An example of this is annuities. We often see overzealous insurance agents overselling the value of annuities, although yes they do have a tax benefit, after costs and ordinary income tax is applied to distributions, the net benefit is usually not as attractive as the brochures would like you to believe. Spreadsheet. In this case, we compared a high cost annuity with income tax applied to distributions, to a low cost index approach with capital gains and qualified dividend rates applied along the way. Not only is the annuity pie smaller, because less was available to reinvest due to high fees, but the final allocation between fees, taxes, and the investor was not as attractive. Tax Treatment and Strategies As we compare Active and Index based investment strategies, the overall after-tax outcome to investors can vary drastically. As we discussed in other parts of this site, high fees and trading costs have a significant negative impact on investors. In addition to this, tax problems associated with high turnover and active strategies cause even more problems for investors. The following table outlines some of these tax problems. Issue Active Index Note Short-Term Realized Gains High Turnover and Short Holding Periods can Subject Investors to this Higher Tax Rate. Low Turnover and Long-Term Investing should Minimize Short-Term Gains. Favors Indexing Strategy. Long-Term Realized Gains Good Active Managers should attempt to push most gains into the Long-Term Classification. Good Index Managers should largely minimize Long-Term gains. Favors Indexing Strategy. High Cost Accounting Good Active Managers and Investment Firm Systems should Utilize High-Cost Accounting. Over the life-time of the index investor, High-Cost accounting can lead to years of deferring low basis positions. Capital Gains when carried into an estate at death have a stepped up basis. Turnover Higher Turnover Active Managers usually leads to higher S/T and L/T Capital Gains. Lower Turnover Index Managers usually leads to lower S/T and L/T Capital Gains. Not all index funds are the same. It's important to understand the turnover of the specific fund an investor is using. Open Ended Funds Active Open Ended Funds have a tendency to have a low correlation of realized gains/losses to actual performance. Open Ended Index Funds can often have high unrealized gains embedded in the share price. An additional issue associated with both index and active funds is whether the fund is attracting or losing assets. Losing assets can increase realized gains, attracting assets can defer gains. Wrap-Fee Programs Some wrap programs can lead to unintended realized gains due to the cookie cutter approach by large financial institutions. Some wrap programs can lead to unintended realized gains due to the cookie cutter approach by large financial institutions. The more specific tax strategies can be implement to your situation, not to the overall program, the more likely the client is better off. Wrap fee programs in general have the tendency to not be client specific. Deferral Active management is usually not associated with deferring gains as a core benefit, although some managers do. Index based management usually considers deferred capital gains as an important part of the overall strategy. Although feels logical to argue that realizing gains now instead of losing money to defer the taxes is better, this logic assumes the asset is mispriced and that an investor can predict the mispricing. This prediction is probably not possible. ETF's Active ETF's are uncommon and the Tax Consequences have little History. Index based ETF's are usually very tax efficient and usually minimize the pass through of Capital Gains. Because of the Creation and Redemption feature of ETF's, often the distribution of gains to investors cans be minimized. However, there are many different kinds of ETF's, and each has unique tax consequences. ETF Tax Guide Tax-Free Bonds Using Active Strategies with Tax-Free Bond Portfolios is likely to increase the Tax burden if successful. The very nature of active management in Tax-Free Bonds is to generate extra return in addition to the Tax-Free income. This extra is a gain in bond price which is a taxable gain to investors. A Tax-Free Bond Index usually delivers little in Capital Gains to Investors. Generating extra returns from Bonds in a Portfolio requires that a Portfolio Manager either predict Interest Rates or Predict changes in Credit Quality. Summary All of the above mentioned items are important to the end result for investors of maximizing after-tax returns. Advisors that don't carefully consider these issues and how they affect client portfolios are not getting as much as they could for their clients. At Garde Capital, we understand the value and importance of tax considerations and apply a thoughtful, holistic approach, to each and every client. Talk to us today about your portfolio and how after-tax results might be improved.