Five Things to Evaluate in a Tax-Managed Investment Strategy

1. Are taxes significant enough to warrant a tax-managed strategy? (Hint: Probably)

Some people think that focusing on investment taxes only matters if you’re wealthy, and it’s true that the more you make, generally the higher your taxes are. But taxes on income rise from 12% to 22% once a couple earns more than $83,000 in taxable income for a married filing jointly status, and the capital gains rate goes from 0% to 15% at almost the same taxable income level.

That means millions of middle-class families can face significant taxes on their investment earnings. These aren’t the super-rich with a fleet of accountants on call. This group tends to be heavily invested in mutual funds. And the data shows that about 47% of dollars invested in mutual funds reside in taxable accounts. That is about $11.2 trillion in taxable accounts. (Source: 2021 Investment Company Fact Book, Investment Company Institute (ICI)) But even though almost half of every dollar invested in mutual funds is taxable, the investment industry tends to focus on pre-tax return. For these assets, it is the after-tax return that matters – not the pre-tax number that is so often displayed.

There are many people who can benefit from a tax-managed strategy, and as they become aware of this, they are increasingly in need of advisors with a strong tax-managed offering.

2. Is the end goal the lowest possible taxes or more after-tax wealth?

You may have heard tax experts say, “It’s not what you earn, it’s what you keep.” I take a broader view: It’s what you earn and what you keep.

Many tax-managed strategies focus just on minimizing taxes. The challenge I often see is this sole focus on tax minimization often means losing sight of the larger goal – higher after-tax wealth. It is the classic line of letting the tax tail wag the dog. The end goal should be more dollars in investors’ pockets after paying Uncle Sam.

Here’s an example for you: An initial investment of $1 million earns 10% with a 0.5% tax drag¹ with manager A. The same initial investment earns 12% but with twice as much tax drag – 1% – with manager B. Manager A is “more tax efficient,” but after you pay relevant taxes, manager B has higher ending wealth of $14,300². The higher pre-tax return more than makes up for the higher tax drag.

Establishing a clear goal is the first step in finding success with a tax-managed strategy.

3. How are assets selected, allocated and optimized?

Establishing a clear goal is obvious in principle, but achieving it requires a lot of thoughtful work. Each asset manager will have their own approach, so take a close look at how a manger decides what assets belong in a strategy. In general, I would recommend looking for:

• Careful asset allocation, with lower exposure to expected less tax-efficient asset classes;

• Optimization, which should consider the inclusion of both active and passive funds, including ETFs, to find a mix that favors funds with a history of attractive after-tax returns and looks to avoid funds that may be tax-inefficient; and

• And a flexible bond-positioning strategy that leans into the tax attractiveness of municipal bonds but also includes taxable bonds. This thoughtful combination diversifies the sources of bond returns to improve after-tax returns.

4. How is tax-loss harvesting managed?

Look closely at active tax-loss harvesting, an approach in which investments are purposefully sold at a loss when market volatility causes fund drawdowns. While no one is looking for funds to go down in value, investors know there are times in the market when asset classes come under pressure, and it happens. When done properly, tax-loss harvesting can create tax assets for investors – losses to offset realized gains to lower taxes in the current year or in the future.

There are different ways to approach tax-loss harvesting. At my firm Frontier Asset Management, we consider tax-loss harvesting opportunities on an ongoing basis, not just at year end like many managers. Through our process, harvested losses belong to the investor, not the fund. When losses are recognized (harvested) within a mutual fund as done in some tax-managed funds, that loss can be used to offset against gains within that specific fund. If there are no gains, the loss can be carried forward into future periods. That may be okay if you are still in the fund at a later date when the loss might be used, but most investors would rather have that loss be in their control to use when and how they determine – not the fund company. Understand the approach used and that it fits your strategy.

5. How does a tax-managed strategy fit into an investor’s overall goals?

Finally, tax-managed strategies should be viewed as just a tool in the toolkit to help investors reach their goals. Any client-focused advisor will know that each person is different, has different goals and risk tolerances, and that needs to be where the conversation begins and ends.

All in the service of the investor

These approaches may not be for every investor, but they offer a good balance of risk management, reduced tax drag, and maximum possible return under those constraints. Look for a fully independent asset manager that is not beholden to any proprietary funds, and is free to use any mutual fund or ETF (active or passive) that its process informs it to use to seek to improve after-tax outcomes. This unbiased, objective approach is rare in the asset management industry.

The best thing an advisor can do is help educate and guide investors through the pros and cons of tax-managed investing. Be their advocate in navigating the tax code in relation to investment choices. Talking the specifics of taxes can make people glaze over, but all investors appreciate the goal of having more money – not less – for their investments.

Frank Pape, CFA, CPA®, is director of strategies at Frontier Asset Management.

This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Past performance is not indicative of future results. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Frontier Asset Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. The use of such sources does not constitute an endorsement. The views expressed represent the opinion of Frontier Asset Management. The views are subject to change and are not intended as a forecast or guarantee of future results.

¹Tax drag is the reduction of potential investment returns due to taxes.

²This example is hypothetical in nature. Calculations are before Advisory Fees. Returns are used for illustrative purposes only and should not be assumed to be representative of any individual account.

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