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Advisors - May 12, 2021

3 Best Practices for Building Tax Efficient Portfolios

It’s often said that only two things are certain in this world: death, and taxes. Every year, tax day rolls around and investors, advisors, and fund managers alike search for ways to conduct more tax efficient investing.

While some fund managers offer mutual funds or Exchange Traded Funds (ETFs) that are created with tax efficiency in mind, there are further steps advisors can take to protect assets and gains from the taxman.

T. Rowe Price Tax-Efficient Equity Fund, DFA Tax-Managed US Equity, Russell Inv Tax-Managed US Large Cap S, Goldman Sachs US Tax-Managed Eq A Total Return NAV% Changes from December 31st, 2015 through May 11th, 2021

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With this in mind, we’ve outlined three best practices to help you build tax-efficient portfolios for your clients, or yourself:


Optimize Use of Tax-Advantaged Accounts

Investment returns can go up, up, and up again, only to be cut by a potentially large fraction upon selling or withdrawal. As taxes are a major drag on returns, it’s important to consider the account in which securities are held so as to minimize current and future tax impacts. Account selection is just one of many tax-related factors that must be considered early in an individual’s financial journey.

Taxable accounts provide greater liquidity and withdrawal flexibility, but don’t carry any tax advantages. Dividends, interest, or capital gains resulting from an asset sale get taxed each time one occurs. Taxable accounts, such as brokerage accounts, are best suited for tax efficient investments, such as passively managed funds, zero-coupon bonds, or no-dividend stocks. 

Tax-deferred accounts are funded with pre-tax dollars. Though any activity in the account — dividends, interest, capital gains — is exempt from taxes, each distribution is subject to taxation. But, contributions to tax-deferred accounts can be deducted from tax returns, thereby lowering the amount of annual taxable income. This makes tax-deferred accounts like a traditional 401(k) or IRA best for both high-income earners and tax inefficient investments.

Tax-free accounts offer a benefit exactly as the name suggests: they are tax-free. Not only is activity within the account tax-exempt, but distributions occur sans tax as well. Because tax-free accounts like a Roth 401(k) and IRA are subject to income limits, it’s best to contribute as much as possible during periods of lower income, as well as store investments that can return the greatest amount.

There’s no avoiding taxes entirely — they’ll either be taken before contributing to an account, or be paid distributions are made. But, optimizing use of the different accounts based on your client’s current and future income levels maximizes investment returns by minimizing the amount paid to Uncle Sam.


Compare portfolio holdings using key tax-related metrics

With the right account(s) identified, you can now focus on tax concerns related to the securities held in those accounts. In addition to a sale event or account withdrawal, individuals can face additional tax liabilities due to mutual fund or ETF managers’ decision-making. Some useful metrics for evaluating funds in YCharts and protecting from potential tax liabilities include:

Tax Cost Ratio – the amount that a fund’s annualized return is reduced by taxes that investors pay on distributions. This includes stock and bond dividends as well as capital gains distributions.

Tax Adjusted Returns – estimates the return an investor may realize after the tax impact of distributions but before selling a mutual fund, ETF, or closed-end fund. These figures use Morningstar’s tax cost ratio and assume the highest income tax bracket, which in turn give a more conservative estimate of tax adjusted returns.

Turnover Ratio/Rate – the rate at which a fund changes out its holdings. A lower turnover ratio indicates fewer holdings changes and a lower risk of distributions and “churning” (transactions for the sake of trading commissions). The Turnover Ratio is usually between 0% and 100%, but active funds can have higher ratios.

Potential Capital Gains – an estimated percentage of a fund’s assets that may be distributed as future capital gains. If a fund holds a lot of undistributed gains, investors may be hit with a tax liability for capital gains that occur before they buy into the fund.

YCharts Fund Screener for Tax-Efficient Funds

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Consider Tax-Efficient Alternatives to Funds

Because of mutual fund mechanics, managers must sell securities in order to rebalance and accommodate redemptions, causing a relatively higher number of “taxable events”. In contrast, ETF managers accommodate asset flows in ways that protect the investor from capital gains on underlying securities. This is especially true with index-tracking ETFs that typically sport low expense and turnover ratios.

However, the possibility of double taxation exists in mutual funds and ETFs alike. In addition to capital gains tax from selling fund shares, selling activity within the fund triggers capital gains events. Those taxes are then passed on to fundholders, whether they approve of the selling or not. To be fair, though, active mutual fund managers can strategically take advantage of capital losses and tax-loss harvesting to mitigate taxes owed by fund holders.

Holding individual securities is one way to prevent a double capital gains tax. If investors wish to steadfastly minimize tax impacts, one investment to consider is municipal bonds, as they are exempt from federal taxes.


Identify tax-efficient investment ideas with YCharts

Screen by Tax Cost Ratio within a Fund Category

The YCharts Fund Screener helps you take a tax-efficient approach to fund selection in any given category. Tax Cost Ratio measures the extent by which taxes on distributions reduce a fund’s annualized return. A Tax Cost Ratio of 0 means the fund made no taxable distributions in the period, and lower ratios generally signal improved tax-efficiency.

Pre-built templates in Fund Screener

The Fund Screener can also help you identify tax-efficient strategies via several pre-built screen templates. The Best Performing Tax-Preferred Bond Funds and Best Performing Taxable Bond Funds templates are especially valuable for fixed income fund research.

Templates are a great starting point as they can be further modified with additional metrics of your choosing. Once narrowed to a manageable list size, use YCharts Quickflows for further head-to-head analysis on factors like performance, risk, sector exposure, and more.

Run a Tax Adjusted Return Comparison Quickflow

The Tax Adjusted Return Quickflow creates a data table that contrasts returns and tax impacts side-by-side in just a few clicks. Choose up to 12 funds and add them to the “Comparison” Quickflow tab, then click “Tax Adjusted Return Comparison”. The output is a single, informative Comp Table that highlights the most tax-efficient funds, and is exportable to Excel in a flash.


For example, this Comp Table is the result of running a Tax Adjusted Return Comparison Quickflow on the Chesapeake Growth (CHCGX), Invesco DWA Momentum ETF (PDP), First Trust NASDAQ-100 ex-Tech Sect ETF (QQXT), and The Investment House Growth (TIHGX) funds.


The Bottom Line

Taxes are rarely a clear cut conversation topic with clients. Income levels, investment goals, risk tolerances, and life itself change over time—and each factor plays into taxes.

But it is possible to be proactive about maximizing returns and limiting tax liabilities owed to Uncle Sam. Using these best practices for tax-efficiency, a little more up-front planning can lay a roadmap for success and maximize the rewards of a well-built financial plan.


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