The Hidden Drag on Portfolio Returns

Just as compounding returns can deliver large gains for investors over time, compounding flaws can frustrate their aims. This is especially true for high earners: Without proper planning, multiple layers of taxation can turn into a collective “silent fee” on their long-term wealth. In some cases, these inefficiencies are small individually, but add up to a significant drag over time.

Our approach is to consider the whole picture, starting with key questions like: Are your assets held in the most tax-efficient investment vehicles? Are you investing in tax-efficient securities and using losses (when they occur) in ways that serve your aims? Are you considering placement of some assets inside of your estate or outside of it in ways that may make things simpler for your future heirs?

There are a lot of ways you can get started. We’ll discuss key opportunities to minimize tax drag in ways that can align with your risk tolerance and help meet your goals.

Which accounts and vehicles can help improve tax efficiency?

It’s often possible to strengthen after-tax returns by simply making sure your assets are held in the right place, as the tax treatment of an investment is sometimes determined solely by the type of account it’s held in.

There are two main factors that determine the right type of account for your investments. One is the purpose of those assets within your wealth plan. The second is the tax treatment of the underlying investments if they were to be held in a taxable account.

For example, traditional Individual Retirement Accounts (IRAs) and 401(k)s are tax-deferred and Roth IRAs are tax-free, regardless of what’s invested inside the account. Typically, it makes sense to place assets in tax-advantaged accounts if you intend to hold them for the longer term—if you’ve earmarked them for retirement expenses or future intergenerational transfer—because accessing them earlier may result in costs and penalties.

As a guideline, it often makes sense to hold tax-inefficient assets like high-turnover trading strategies or high yield bonds in a tax-advantaged account. Placing these assets in one of these tax-advantaged accounts will allow you to defer tax payments, allowing for more gains to accrue. In a taxable account, the higher tax rates would erode your returns to a greater extent.

Assets that are highly tax-efficient, such as municipal bonds or low-turnover U.S. large cap stocks, are more likely to belong in a taxable account, as deferral could leave them subject to different, higher tax rates in the future.

This is why it’s important to make a comprehensive plan, and update it regularly: Once you know how much funding you’ll require to meet your current needs, you can put your assets to work on longer-term plans.

For clients that have exhausted the allocations in traditional tax-advantaged accounts like IRAs, two underappreciated vehicles that get favorable tax treatment are private placement variable annuities (PPVA) and private placement life insurance (PPLI). Under most circumstances, taxes on annuities are deferred, while life insurance death benefits are generally received income-tax-free. This means that investments in these vehicles can grow in a tax-efficient manner even after factoring in the cost of purchasing the annuity or life insurance policy. They can also be used to fund legacy and charitable goals. Your J.P. Morgan team can help assess if these are worth considering, and the most impactful strategy for structuring them.

Portfolio choices that can help reduce tax drag

We’ve seen that choosing the right account “wrapper” (taxable, tax-deferred, Roth, etc.) can contribute to your returns. It’s also worth asking how you can mitigate tax drag outside of that wrapper to keep taxes from quietly eroding returns. These approaches can improve after‑tax outcomes, with tradeoffs to consider with your J.P. Morgan team.

• Realizing losses deliberately to offset gains: Using tax loss harvesting techniques to realize investment losses can help reduce tax liabilities. Simply put, tax-loss harvesting is the timely selling of securities at a loss to offset realized investment gains elsewhere in your portfolio. This provides an opportunity to lower tax bills, allowing investors to keep more of their returns. Effective implementation generally includes attention to wash sale rules, transaction costs, and maintaining the portfolio’s intended exposures.
• Choosing securities with more favorable tax characteristics: Security selection can help improve after-tax outcomes by emphasizing investments whose income may be exempt from federal (and in some cases state and local) income taxes, like municipal bonds. In practice, investors often evaluate municipal bonds relative to taxable alternatives using an after-tax or tax-equivalent yield comparison.
• Meeting liquidity needs without unnecessarily realizing gains: Borrowing against your assets in a tax-aware fashion, instead of selling them and potentially triggering capital gains taxes, can help investors stay on track. Borrowing can provide liquidity while deferring the realization of gains that may occur if appreciated positions are sold. This approach is typically considered alongside the costs and risks of leverage—such as variable borrowing rates, collateral requirements, and the possibility of forced sales during periods of market volatility.

How estate planning supports a more tax-efficient portfolio

Estate taxes also require careful planning: Without an adequate plan in place, you or your heirs may be subject to costly missed exemptions and credits, lack sufficient liquidity to pay estate taxes without selling assets, or face residency-related taxes.

While estate planning is complex, there are a wide variety of steps you can take to minimize estate taxes and preserve wealth for your heirs and the causes you care about. In brief, these include:

• Using the estate tax exclusion¹
• Arranging asset swaps or borrowing in advance to pay estate taxes, which can prevent forced sales of valuable assets
• Gifting to lock in the present-day values of assets that are expected to appreciate significantly

Acquiring life insurance to pay estate taxes can also help create a more efficient transfer of wealth. Life insurance is often held in an entity outside of the estate itself, and since life insurance is paid out to future generations, placing it in an entity outside of your estate — such as an irrevocable trust — can help shield the benefit from estate taxes while providing liquidity for heirs and beneficiaries to handle liabilities like debt and taxes. Asset titling, or determining ownership, is a key part of the estate planning process. Deciding which assets should be held within your estate and which should be kept in trusts or other vehicles is a key decision to help create a more tax efficient approach.

How taxes can shape portfolios

Where you live can have a significant effect on your wealth because of the different ways U.S. states tax income and assets. It’s a highly personal choice, but if you’re open to the idea of moving from a higher-tax state to a lower-tax one now or in the future, it’s critical to know the methods each state uses for determining legal residency for tax purposes. Otherwise, you may go through the difficulty of moving without getting the corresponding tax benefits.

Bringing a tax-efficient portfolio together

No matter where you are in your life or your career, you may find it worthwhile to review your wealth plan and look for opportunities to pursue your goals in a more tax efficient manner, but that doesn’t have to mean redesigning your entire portfolio.

 Partnering with your J.P. Morgan team, you can make progress one decision at a time, focusing first on changes that preserve your investment plan while improving after-tax efficiency, and then layering in additional techniques when they’re a good fit. Tax efficiency can help you keep more of what you’ve earned, but the right moves are personal: Not every strategy fits every investor, every account type, or every year. 

A more tax efficient approach

To learn more about implementing a more tax-efficient strategy in ways that can serve your chosen goals, contact your J.P. Morgan team.