Reducing your portfolio’s tax exposure can produce enormous benefits.
At J.P. Morgan Private Bank, we create portfolios for individuals. A crucial part of this is considering a portfolio’s tax exposures because long-term investment success is not just about what you earn from your portfolio but what you get to keep on an after-tax basis.
A one-size-fits-all approach rarely provides the strongest solutions when it comes to tax-efficient investing. Our highly personalized approach focuses on determining the most effective tax-aware portfolio strategies that suit your specific situation and goals.
With that in mind, we take four key steps to help build and manage a more tax-aware portfolio for you.
1. Review the types of assets in your portfolio
The types of assets that go inside your portfolio can be incredibly important from a tax perspective. This includes both the kinds of underlying securities and investment products that populate your portfolio allocations. We help to ensure that you aren’t giving away a substantial amount of your portfolio gains to taxes, by being mindful of how various assets may affect your potential tax exposures.
- By underlying security—Municipal bonds, preferred stocks, private equity investments and real estate can all offer attractive tax-advantaged characteristics. Learn more about the tax implications of various asset classes here.
- By investment product—Before investing in a specific strategy, we think carefully about the types of returns that the manager is likely to bring to the portfolio. We are conscious of managers that may increase tax liabilities through significant short-term trading, as well as where these strategies might best fit into a portfolio.
The goal is to understand how all of the individual components of your portfolio are working together and if there are opportunities to capture specific tax efficiencies and increase overall performance potential on an after-tax basis.
Actions we take: We often help clients access investment products with attractive tax attributes, such as tax-optimized passive investments. We can also help you compare different investment options within the same asset class, such as Treasuries versus municipal bonds, to evaluate which is likely to provide the strongest after-tax results. For example, a municipal bond earning 0.92% has a taxable equivalent yield (TEY) of 1.55%**. Comparing the TEYs of different bond securities allows an investor to better evaluate the investment from the viewpoint of what will result in a better end result for the individual.**
**Rates as of 9/1/2021 for a 10 yr AAA rated municipal bond general obligation and taxable equivalent yield calculated assuming 37% Federal marginal rate plus 3.8% Medicare surcharge.
2. Assess your assets’ location
Once we know what the portfolio will own, we are mindful about where to own it. The type of account an asset is held in can help dramatically reduce a portfolio’s tax exposures.
The general rule is to hold tax-inefficient assets inside tax-advantaged accounts.
Here’s why: Tax-deferred account structures delay income tax liabilities until assets are withdrawn, making them a great choice for investments that generate considerable ordinary income or short-term capital gains. Further, different types of trusts can be shielded from transfer taxes, which can make them ideal candidates for potential high-growth holdings. Learn more about the importance of asset location here.
The timing of when you plan to use different asset “buckets” of capital that target various goals can also help determine where various components of your overall allocation should be held from a tax perspective. Learn more about this bucketing approach here.
Actions we take: We often consider whether it makes sense to try to place hedge funds and other investment products that tend to generate considerable short-term capital gains into tax-advantaged accounts.
3. Tap into tax-smart trading strategies
There are a number of tax-smart trading strategies that we can incorporate into the ongoing management of your portfolio. The specific trade approach depends on the desired goal for the portfolio’s underlying market exposures.
- To maintain a similar market exposure—When losses exist, selling one exposure and buying a similar one can help to harvest a tax loss, which then can be used to offset gains elsewhere. This action ensures that you continue to be in a similar market so that you don’t lose exposure to an investment view. To utilize the tax loss, note that you have to comply with specific rules, including a prohibition on purchasing a substantially identical exposure. You should consult your tax advisors to ensure you comply with these requirements and to ensure you can fully utilize any resulting tax loss.
- To change market exposure—Such a move may be attractive when a new market exposure appears to offer greater risk/reward potential. The key is to be hyperconscious of whether the expected outcome from the change more than offsets its tax cost.
- To transition existing assets tax efficiently—With many strategies, positions can be funded “in kind” through security transfers. Rather than sell and then buy back a position, which may involve a capital gains realization, you can consider moving an existing holding from one strategy to the next if there is an overlapping exposure. Learn more about what you can do with capital gains here.
Actively managing the tax consequences of trading strategies throughout the year can help capture timely tax-saving opportunities as they present themselves and ensure the portfolio is well-positioned to help you keep more of your earnings. If you seek to generate consistently better after-tax total returns, this requires constant monitoring, not just at arbitrary, fixed times, such as quarter or year end.
Actions we take: Here’s an example of a recent tax-smart strategy. Our CIO Team has a disciplined process as it relates to tax awareness. There is a monthly review of tax-loss harvesting opportunities, which is particularly beneficial during periods of market volatility, such as in late 2018 or early 2020. Recently, our CIO Team shifted exposure within our discretionary portfolios from the broad industrials sector to a more targeted machinery exposure based on their fundamental market view of the sub-sector’s stronger risk/reward dynamics. Rather than selling all of the current industrials position, the CIO team was able to sell just the non-machinery securities, while continuing to own and add to the targeted machinery holdings, allowing for greater tax efficiency. The ability to retain only a subset of the broad index would not have been possible if portfolios were using a traditional active manager or passive ETFs or index funds.
4. Look at your “big picture”
Because we take a custom approach, we can better manage the intersection of your overall financial picture with the most efficient tax strategies for your portfolio. Some of the main considerations for effectively managing this integration include:
- Assessing your capital loss carryovers—Capital losses from previous years can be used to offset current gains and potentially provide greater flexibility for repositioning. Also, staying aware of any losses or gains that you have realized outside of your J.P. Morgan portfolio can help better inform actions taken within it.
- Considering charitable giving strategies—Whether it is identifying a highly appreciated position to gift directly to charity or aligning a large charitable deduction in a high-income year, we can help you navigate both donation size and funding sources. Learn more about tax-effective charitable giving strategies here.
- Being mindful of estate planning strategies—By understanding your wealth intentions for your family members now and in the future, we can work with you and your tax advisors and help coordinate wealth transfer strategies with your investment portfolio to help capture potential tax efficiencies. For example, funding a dynasty trust for your grandchildren and investing it more aggressively given its longer time horizon can help optimize the growth that happens off of your balance sheet, thus shielding it from future transfer taxes.
- Integrating cashflow management considerations—We can help you manage singular or periodic occurrences and goals around cashflows, such as large cash-bonus payouts, a home purchase or the need for ongoing portfolio withdrawals. For example, we can make sure that liquidity is raised in a tax-efficient manner and help explore strategies, such as a portfolio line of credit, to avoid triggering unnecessary gain realizations when there may be a possible cashflow timing mismatch.
- Keeping an eye on concentrated positions—With the market continuing to soar, many investors may now be exposed to new or increased existing concentrated positions. Whether you’re looking to support your current lifestyle, future retirement, family, charity or legacy—or some combination of these—there are several wealth planning techniques we can use with your portfolio. Understanding the goals you have for your wealth can help guide which strategy may make the most sense to navigate your concentrated holding in a tax-efficient manner.
Operating your portfolio in concert with what’s happening in the rest of your financial life can help us deliver more optimal solutions.
We’re focused on you
Fine-tuning a portfolio for tax efficiencies can be a complicated and ongoing process—but you don’t have to do it alone. We take a highly personalized approach to optimizing potential tax exposures for each client’s portfolio. (Keep in mind that the illustrative examples above are general in nature.) Your J.P. Morgan team can offer you more details about the tax-aware strategies that they are applying for your specific situation.