The Zen of Tax Management: Tax-Efficient Investing

Tax-efficient investingYou’ve heard the phrase “tax season.” You’ve probably even said it a few times.

Advisors even throw the phrase around, inadvertently implying that there is an optimal time to think about your income taxes. Honestly, it’s pretty misleading. The best way to minimize your annual taxes is to engage in year-round tax-wise investing.

Embrace these personal habits to make tax-efficient investing a way of life.

The Most Important Habit and What to Do with It

Investing according to a plan makes everything else easier to accomplish. Preferably, this will be in the form of a written Investment Policy Statement that clearly defines and documents what you plan to achieve with your investments and how you plan to achieve it. By doing this, you and your financial team are best positioned to ignore the inevitable, often tax-incurring distractions along the way.

A detailed investment plan also serves as your reliable guide for resolving any conflicting priorities when balancing tax efficiency versus other considerations of your overall wealth management.

But it’s not enough to develop a plan. You have to follow it, even when the market is volatile. The most important habit is just that: Develop a plan and stick to it.

Once that piece is in place, you can begin to reduce the number of opportunities you give the IRS to tax you.

How to Avoid Giving the IRS Extra Opportunities to Tax You

The more trading you do in your taxable accounts, the more “opportunities” you create to be taxed on the proceeds. The fewer trades required to accomplish your investment plan, the better off you’re likely to be when taxes come due. (See how that plan is already coming in handy?)

Make sure you avoid hyper-trading in taxable accounts.

You should also make good use of tax-sheltered accounts, such as IRAs, Roth IRAs, 401(k)s, 529 college saving plans and health savings accounts (HSAs). It stands to reason that the more assets you can hold in tax-sheltered or tax-free accounts, the more opportunities you have to avoid or at least postpone the tax ramifications otherwise inherent in building capital wealth.  

One Reason You Still Aren’t in the Clear

Let’s say your investment plan calls for holding a diversified mix of domestic and international stocks in your taxable accounts. Unless you’re planning to invest directly in thousands of individual securities (which we generally advise against), you will need to choose one or more funds to make up the desired mix.

That’s where the challenge begins. Even if two funds share identical investment objectives, one may be considerably better than the other at tax-efficiently managing its holdings on your behalf.

It’s easy for fund managers and investors to ignore this important detail, because not all dollars lost to a fund’s tax inefficiencies show up in its published returns. Some of them may show up as annual capital gains distributed to fund shareholders (i.e., you), so you end up having to pay taxes on the gains at their individual tax rate. It doesn’t matter if the fund went up or down.

When a fund that has dramatically plummeted in value is forced to sell highly appreciated holdings to meet shareholder redemptions, all shareholders must then share the burden of paying taxes on those realized gains, even if the fund value itself has declined. Ouch.

To minimize such scenarios and otherwise soften the blow of your fund’s taxable trading activities, it’s worth seeking out managers who exhibit best tax-management practices, especially for funds that you plan to hold in your taxable accounts.

Take Matters into Your Own Hands with These Three Actions

Avoid actively trading funds in favor of evidence-based investing. Just as you should minimize your own hyperactive trading, your fund managers should do the same by heeding the academic evidence on how markets operate.

Most managers try to “beat” the market by actively picking individual stocks or forecasting when to be in or out of it. Instead, look for managers who are seeking to build lasting value by patiently participating in the long-term growth expected from the return factors being targeted.

Evidence-based investing is not only a more sensible overall approach, it also is typically more tax-efficient.

Avoid hyperactive shareholders. It’s best to invest in funds in which your fellow shareholders are less likely to panic-sell during bear markets. Undisciplined investors may force a fund manager to liquidate appreciated holdings to fund their flight. This incurs distributed capital gains that you, as a fellow shareholder, must shoulder along with them.

Investors who form personal investment plans, adopt an evidence-based strategy and choose like-minded fund managers to help them implement their plans should be better at retaining their resolve, even during volatile markets.

Seek out tax-managed funds for your taxable accounts. Some fund families offer versions of their evidence-based funds that favor tax-friendly trading over maximizing gross returns with no regard to the taxable consequences. Tax-friendly trading can include practices such as avoiding incurring short-term (more costly) capital gains, and more aggressively realizing available capital losses to offset gains.

Are You Tax-Wise?

Are you following these practices? Contact McLean today to discuss tax-efficient investing in your portfolio.

Read Part Two – “Are You As Efficient as Possible?”


McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.

The information throughout this presentation, whether stock quotes, charts, articles, or any other statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither our information providers nor we shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission there of to the user. MAMC only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. It does not provide tax, legal, or accounting advice. The information contained in this presentation does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before making any decisions.

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