With Tax Day approaching and investment returns harder to come by of late, how much you save on taxes can boost your portfolio’s performance and income. A strategic approach toward managing a portfolio’s taxes – namely tax-loss harvesting and tax deferral – can help lift after-tax returns by about 2% per year, according to Neuberger Berman . The boost is known as tax alpha. Tax-loss harvesting refers to strategically pruning losing positions to realize losses and offset capital gains elsewhere in your portfolio. You don’t have to be a million-dollar investor to realize the benefits of these strategies – or to make missteps that could cost you money at tax time. “This is a broad generalization, but most people have no idea how their portfolio impacts their taxes,” said Catherine Valega, certified financial planner and enrolled agent at Green Bee Advisory in Burlington, Mass. “Most people have no idea how their assets work and combine to relate into what their tax bill will be.” Using income now or later The tools you need to manage the taxes paid now and in the future include taxable brokerage accounts, tax-deferred accounts (like your 401(k) plan or individual retirement account) and tax-free accounts (including your Roth IRA). Which of these accounts you choose for your income-generating holdings will depend on your priorities, according to Christine Benz, director of personal finance and retirement planning for Morningstar. “To the extent you prioritize income producers, you’ll want to focus your attention on your tax-sheltered vehicles in an effort to avoid having to pay taxes on those distributions,” she said. Tax-deferred accounts, for instance, might be a great place to keep high-yield and corporate bonds and the funds holding them. That’s because the interest income they produce is subject to ordinary income tax rates, which can be as high as 37%. Real estate investment trusts are generally another contender for tax-deferred accounts, due to the sizable dividend yields they offer. By holding them in an IRA, investors defer taxes on the dividends they receive until they begin withdrawing income. Dividend-paying stocks and funds may be contenders for taxable brokerage accounts, particularly if the dividends are taxed at the same rate as capital gains (0%, 15% or 20%) and the investor is planning on spending the money. “You still get distributions year in and year out, so unless you’re looking for spending money, even dividend-paying stocks may be better in a tax-sheltered account, where you aren’t paying taxes year to year even at a lower rate,” said Benz. Municipal bonds , which offer tax-free income at the federal level – and at the state level if the investor is a resident of the issuing state – could best belong in a brokerage account. However, Treasury bills could go in either taxable or tax-deferred accounts, depending on the time horizon and how the interest income is being used, Benz said. The tax-season sweetener for Treasury interest income is that it’s subject to federal levies but exempt from state and local taxes. US1Y 1Y mountain U.S. 1-year Treasury bill yield over the past year. “We went through periods where yields were so low for so long that nobody thought about the income they might’ve received, but if you’re not using cash for living expenses, it may make sense to keep them in a tax-sheltered account,” she said of T-bills. Consider that while the yield on the 1-year T-bill is well off the highs it hit last year when it surpassed 5%, it’s still yielding roughly 4.1%. Managing taxes on portfolio income In addition to being mindful of asset location, Valega uses a strategy with her clients that’s known as direct indexing . This entails buying the individual stocks of an index and then managing the portfolio to benefit from tax-loss harvesting by trimming losing positions and offsetting realized gains. For high-net-worth clients, she’s been using portfolios of individual muni bond issues on the fixed income side. She prefers this over buying muni bond mutual funds or exchange traded funds, as her clients intend to hold onto their issues until maturity and would rather not be subject to the price swings seen in bond funds. She encourages investors to stash 12 months to 18 months of expenses in an emergency fund, and while this comes with a tax bill – interest from certificates of deposit and most money market funds is taxed at the same rate as ordinary income – it’s not as much of a surprise as it might’ve been a year or two ago. “Why are your taxes higher? Because you earned some nice income,” said Valega. “We are a year or two down that cycle, and people are starting to be aware that it’s an issue, but it’s a nice problem to have.”
