It is important to manage a portfolio in a tax-wise fashion to help maximize your return in the long run. There are several strategies that can be used to do that, here we discuss them.

  • Asset Placement: different asset classes produce different amounts of recurring taxable income with different classifications under the tax code. Common stock dividends are usually treated as “qualifying dividends” if you hold the stock for a certain time (typically 60 days for common stock). They are taxed at the same rate as the capital gains rate that is applicable to your marginal tax bracket (0%, 15% or 20%). Income from REIT’s and bonds is taxed as ordinary income so it may be taxed at a rate as high as 37% (the top bracket in 2018). You can increase tax efficiency by holding those types of asset classes in your tax-deferred or tax-free accounts. Some assets also generate a lot of recurring income in particular natural resources, and alternative investments. Typically, we recommend the following holding order for different asset classes:


Preferred Account Type Note
Natural Resources Tax Deferred High recurring ordinary income
Alternatives Tax Deferred Frequent tax events
International Bonds Tax-Deferred High Income tax free not available
Real Estate Tax-Deferred High income does not qualify for special dividend rate
Bonds Either Can purchase tax-free municipals in a taxable account
International Stock Taxable Dividends not qualified but not as high as other asset-classes
Domestic Large Taxable Dividends taxed as qualified
Domestic Small Taxable Dividend rate low, taxed as qualified.
  • Choosing more efficient vehicles: Mutual funds are not generally tax efficient, they must distribute all, or substantially all (90% or more) of net investment income and at least 98% of capital gain net income to the shareholders annually. Sometimes because of this it might make sense to hold off from investing in a mutual fund during the last 2-3 months of the year. Buying a fund late in the may lead to receiving part of your investment back as a capital gain distribution creating a taxable event. That can happen even if you really have no gain in the fund. Another disadvantage for the mutual fund type investment vehicle is that amounts a mutual fund distributes can be dramatically increased if it suffers a round of shareholder redemptions. When that happens fund, managers may have to sell highly appreciated stock to fund the redemptions with the resulting capital gains that are realized distributed to the existing shareholders that are left behind. Exchange Traded Funds (ETF’s) do not have to distribute their gains to shareholders, they can be retained, reinvested with the gains reflected in increased share price for the ETF. ETF shares are also do not have the disadvantage that mutual funds have with redemptions; ETF shares are not redeemed instead they are sold on markets like a stock instead of the shares being wiped out by a mutual fund company they are purchased by someone else. If you are in a higher marginal tax bracket, ETF’s may be the preferred investment vehicle.
  • Proper bond selection: Bonds can be held in either taxable or tax deferred accounts. If they are held in a taxable account and you are in a high marginal bracket you can purchase municipal bonds therefore we are relatively indifferent to which account should hold them. It is important to know what your marginal bracket is to determine if the tax equivalent yield for a municipal bond is at least as high as the yield on taxable bonds.
  • Capturing losses: Capturing losses may not always provide the benefit one imagines. When you sell an investment that has declined from it’s purchase price to a lower value, if you sell at the lower value and use the proceeds to purchase another investment that investment will have a cost basis that equals the value at which you sold the losing stock or fund. If the new investment appreciates back to the original value of the first investment and you sell you have now paid tax on a gain that equaled the prior loss. Therefore, capturing losses is really only a deferral of taxation. In effect your real gain from the transaction is only on the earnings you received on the money you did not pay in taxes. Capturing losses does make sense in some circumstance thought for example if you want to offset gains in the same year and there is a good chance you might be in a lower tax bracket in the future possibly due to retirement or a reduction in tax rates (as we just experienced).

Knowing what tax bracket, you are in and in particular what marginal bracket you are in is important in determining which strategies are most useful to improve the net after tax return for your portfolio. Proper tax management of a portfolio can improve your net return (after expenses and taxes). Some estimate that your realized return can be as much as .25% higher annually.

Stephen C. Craffen