Using tax optimization to enhance portfolio returns

When it comes to investment, tax optimization is a strategy often overlooked by individual investors. While asset allocation is clearly recognized as one of the major determinants affecting returns, minimizing taxes and expenses should be regarded as equally important. By utilizing a tax optimal strategy, not only can expenses likely be lowered, but portfolio returns may be enhanced over time. Without proper planning for paying tax, a significant amount of the gains of a portfolio can disappear. In a worst case scenario, poor tax planning will dwarf the negative impact of management fees and other investment costs.

The good news is that tax is one area over which an investor can exercise a great deal of control. It is considerably more difficult – some would say impossible – to exert the same kind of control over a portfolio of investment assets, even a fully diversified one. Financial markets, by their very nature, are inherently unstable.  

As everyone knows, income streams from different types of investment assets attract different taxes and tax rates. Moreover, the numerous taxes applied to assets vary from country to country, and in the US even from state to state. This allows an investor to consider an optimal investment portfolio, not based on potential gross returns, but from a net of tax perspective. Individuals will need to review the tax rules in their home country as part of a prudent tax optimization plan.

For the purposes of this article, we will look at assets for a traditional portfolio of investments, so the three main traditional income streams which attract tax are as follows:

• Interest income generated through interest paid on bonds and other forms of debt investments
• Capital gains generated through the appreciation of investments
• Dividend income generated through dividends paid by individual stocks

Something for individual investors to note when investing in funds – as opposed to direct investment in stocks and bonds – is that they can generate all three types of income, depending on the underlying assets of the fund.  The structure of a fund will be described in its prospectus, and a standard mutual fund will clearly state the percentage of income expected to be derived from each source.

Further, investors need to be aware of the distribution schedules of mutual funds in which they are invested. These are also usually published by the funds. Distribution will in most cases trigger a tax event, and dictate the tax year in which the income will need to be declared by the investor. If this type of information is not available from the prospectus, it is worth asking the fund management company to provide the information.

Investment in tax-deferred vehicles, where the gain will be capital in nature and not paid until the asset is sold, gives investors some added flexibility. They can choose the year they will pay taxes on a gain. This applies particularly to countries with graduated tax rates, allowing investors to pay lower tax rates on income simply by ensuring they dispose of an investment before or after a tax year end. 

Other important considerations

Rebalancing

Rebalancing of a portfolio may trigger a tax event because it involves the selling of investments, albeit to fund other investments, and capital gains (or losses) may arise. This can lead to additional costs, and reduce the expected returns. Any rebalancing plans for a portfolio should be carefully assessed for the tax implications.

Estate Duty

Planning in countries which have an estate tax is crucial for wealth preservation. The determination of how different investments and holdings will be taxed for beneficiaries over multi-generations will, without doubt, impact the amount of wealth that is actually retained for the family.

Tax Free Savings

Many countries also have some form of tax-free savings or investment programs, and these should always be used to the maximum limit. 

Overall portfolio growth is the key goal of any individual in managing their wealth. While tax may potentially be one of the biggest expenses for an investor, too often it is overlooked during the planning and execution of transactions. Being aware of this, and planning for tax, can enhance the net performance of any portfolio.

Finally, consultation with a tax professional in your country is always a recommended step. Many wealth management professionals are not necessarily tax experts, so once a wealth manager presents an investment plan it is worth paying additional to consult a tax professional.