Investment strategies with taxes in mind

This material is for informational purposes only and is not intended to be an offer, recommendation or solicitation to purchase or sell specific investment strategy, any security, or insurance product, and should not be construed as legal, tax or accounting advice. Please consult with your legal or tax advisor regarding the particular facts and circumstances of your situation prior to making any financial decision.

Thomas: I'm Thomas O'Keefe, Managing Director of Investment Strategy.

Phil: I'm Phil Neuhart, Head of Market and Economic Research. Today, we're here to talk about something that's exciting to everyone: taxes. We are very interested, and our clients—especially private wealth clients and taxable institutional clients—they're very interested, of course, in portfolio performance, but something that comes up continuously is taxes, right?

In the end, taxes are just a drag on performance. So today, we want to talk about some ways that we think about taxes in investment portfolios. And Thomas, you spent a lot of time thinking about this, so really want to hear from you today on some of these various approaches that we take when thinking about taxes inside portfolios.

Thomas: Yeah, absolutely. And I want to make it very clear—we are not giving tax advice. We're not talking about tax planning. There's lots of tax planning strategies that we could get into with our planning team. Not talking about how to file your tax returns. This is purely a conversation around, from an investment perspective, how do we look at taxes and that drag that you mentioned? And how do we try to manage it, optimize it or potentially reduce it with some of the strategies that we have within our portfolios?

So let's get started. One of the easiest and maybe the most obvious ways that we think about this is just in our bond portfolios. Bonds typically have interest and dividends associated with them, which are taxed at normal income, ordinary income rates.

Those on treasury securities are exempt from the state and local tax. Not exempt from federal tax, but exempt from state and local tax. This is compared to, say, a corporate bond, where those bonds are actually fully taxed at both the state and federal level. So we get a little bit of a break if we invest in treasuries.

Now the bigger break comes when we look at municipal bonds. So municipal bonds are issued by local governments. These are states. These are cities. These are sort of other agencies within our local governments. And the interest that is earned on municipal bonds are actually completely exempt from federal income tax and can be completely exempt from state taxes as well, most predominantly if you are in the state that the bond is being issued. So you could have a situation where your bond is actually completely free of state, local and federal taxes.

Phil: So depending on your tax rate, particularly if you're in a high tax bracket, this could be a really material impact when you consider you're getting interest and not paying any taxes on it. I mean, I know that's simple, but am I understanding that correctly?

Thomas: Yeah. That's exactly right. But there's some caveats to it. We need to think more than just paying no tax is a good thing because generally municipal bonds are going have a lower yield than their counterparts. And so we need to look at a break-even point of, well, how much tax are you paying—and are you actually—that benefit of paying no taxes with the lower yield that you're accepting, is that worth it or not? So what we end up finding is, you know, folks in very high tax brackets, folks in very high tax states, tend to benefit most from municipal securities.

Phil: So I've heard this term tax-equivalent yield. What is that? How does that relate to the yield you were talking about with municipal bonds?

Thomas: Yeah, so this is that break even that I was talking about. So if you compare, say, a corporate bond with a municipal bond, generally, all things considered equal, that corporate bond is going to have a higher yield than the municipal bond. So what we're looking for is, is the tax benefit that you're getting from that advantageous to you comparing those two yields?

And so we can do one of two things. We can either look at that higher yield and we can take, subtract the taxes out of it and see if that yield is higher or lower than the municipal. Or we can do the opposite. We can gross up. We call it the grossing up, the municipal yield. And now we've got two yields that we can compare on an even level instead of one that's pre-tax and one that's—

Phil: And that that tax-equivalent yield is going to be different for all investors, right? Because, of course, your tax bracket could vary depending on your income.

Thomas: That's exactly right. And so what we like to do is we like to take a very flexible approach for all of our clients and make sure that we understand their particular situation. Again, if you're in California, Massachusetts, New York, a high tax-paying state, then we might look more closely at municipal bonds, whereas if you're in a tax-free state, then maybe we won't look at it as much. But we will do the analysis to see what is the most optimal situation for you.

The next one—that was the most obvious one—the next one is really about the vehicle structure that we're looking at, and there's different vehicle structures that have different efficiencies to them. The most obvious is exchange traded funds. So if we're looking at getting into an investment, we can get into a mutual fund, we can get into, you know, single securities, we can get into exchange traded funds. We call them ETFs.

ETFs can be very tax efficient, predominantly due to the in-kind redemption mechanisms that they have, but also they tend to have smaller capital gains distributions. So if you think about a fund that you're invested in, a capital gains distribution is going to be a taxable event for you, and that's when you're going to pay taxes. And so ETFs tend to be very efficient, especially from a tax perspective.

Also, we think about turnover. So really all turnover is—it's a word we use a lot—it really just means how much buying and selling is happening within a portfolio. And so when we're actually looking at funds that we want to put on platform and invest in our client portfolios, one of the key metrics we look at is how much turnover there is. So turnover means taxable events. It means that there is a tax component or liability to it. And so if we have a fund that's generating lots of trades, then that means that there's a potential for lots of taxes.

That's not necessarily a bad thing. Maybe the strategy warrants lots of trades and lots of turnover, but we just want to make sure that that is appropriate and that we are paying taxes for the right reasons.

Phil: Right, it's the classic is the juice worth the squeeze, right? If a portfolio manager is trading a lot, you see a lot of transactions, i.e. turnover, is that generating alpha—or excess performance, excess return is another way of saying that. If it's not and it's just increasing your tax bill, it may not be worth it.

Thomas: Yeah. Think about if we were to compare two random funds, both with the same return, same general portfolio, but one of them turns the portfolio over 50% a year versus the other one that turns it over 10% a year, that 50% turnover is going to create a tax liability, which is going to be a big drag on your portfolio. So we tend—again, all things being equal—we would tend to have a preference for the portfolio that has lower turnover.

And the final thing just in the terms of, sort of, vehicle structure that we like to look at is really the complexity. And so we look at things like what kind of tax filings. Private limited partnerships are going to have K-1 tax forms versus 1099s for more of your mutual fund ETF investments.

These can be very limiting for clients. A K-1, depending on the vehicle, can come out after tax time, and you could have to file extensions. So it just elevates the complexity for a client in terms of their tax filings. For some clients, this doesn't matter at all. They're going to file an extension anyway. For some clients, this can be a massive burden. This can be something that is really a make-or-break for an investment in terms of, you know, how much do you want to spend on, you know, your tax filing and extensions and how difficult that is.

Another thing we look at—especially for more complex investments—is how many states are you filing in, right? If you have to file in just one state versus filing in 25 states, that might actually add another layer of complexity. So again, not necessarily a dealbreaker for clients, but something we consider.

Phil: What about low-cost-basis gifting? It's something you hear a lot about, among particularly wealthy individuals. Let's dig into that a little bit from an investment perspective.

Thomas: Yeah, that's right. So something we're always conscious of, especially if we think that markets are rising over time. And certainly over the past decade or so we've seen equity markets increase substantially. So what are we left with? We're left with portfolios that have a lot of embedded gains in them.

So there's certain things we can do, and I should caveat that having gains is always a good thing, to be clear. If you have gains, that means that your performance is good and you've picked the right investments. So we never like to say gains are bad, but we do want to understand what are the mechanisms to realizing those gains in a way that is very tax efficient. And sometimes the answer to that is not realizing them at all.

And so if we are philanthropically inclined and we already have a plan in place to donate to whatever our charities are, it's possible for us to donate these low-basis stocks, low-basis investments to a charity. It could be a donor advised fund. It could be a private or public charity. It could be directly to the 501(c)(3) that we're looking at.

Again, this is more of a planning conversation than an investment conversation, but what we can do from an investment perspective is make sure that we have vehicles that are properly set up to be able to gift maximum value—basically meaning we pay the least amount of taxes on that. The example that we like to use a lot is separately managed accounts. So where you could have one vehicle structure, which is a mutual fund where you own a piece of the entire pie, you could set up instead a separately managed account where you actually own the underlying holdings. You personally own them in your account.

So that means we're going to have larger holdings that have larger capital gains embedded in them. And so those we can—instead of donating the piece of the pie—we can find the one piece, the one security that we want to actually gift that may have a very, very large embedded capital gain in it. So we're maximizing our gifting through not paying tax on that appreciated—

Phil: Yeah, using an SMA in that way. What about when you look at the portfolio as a whole, tax overlay strategies? What does that mean, and what does that look like?

Thomas: Yeah, there's a few ways we can look at managing taxes in a portfolio over time, and a lot of this just has to do with being thoughtful around the client's particular willingness or ability to take on that tax liability.

And so what we can do is we can put a budget—and this is, again, this is very much dictated by the client situation, less so from an investment perspective on what we think the optimal portfolio is. But if a client can only take, say, a certain amount of taxes per year, they've consulted with their tax advisor and that's the number they're looking at—or a range that they're looking at—then we can actually set parameters on the entire portfolio, and we can say we're only looking to generate X amount of gains through rebalancing, through turnover, through different mechanisms we would normally do. We can start to limit them or accelerate them based off of the client's specific need in a particular tax year.

Phil: So a pretty sophisticated approach, it sounds like—multifaceted?

Thomas: Yeah, and very flexible, which I think is the point, where every single client is going to demand a different approach and solution to this.

Phil: So a phrase that I think a lot of our clients probably have heard of is tax-loss harvesting. Again, what is that? How is that different than tax overlay? Could you kind of specify specifically what we mean when we say tax-loss harvesting?

Thomas: Yeah, it's a great tool, and I think I said earlier we always like gains. Gains are always good. But sometimes we have losses in our portfolio. And so when we do have losses, we have the ability to quote-unquote bank those losses in a particular year. All that means is we can sell a particular security right now today. That is a loss that we can use to offset any gains that we have in that specific tax year.

What it does then is it resets your basis, and then it'll grow, and we're essentially deferring that tax payment to a later year. Now there's many strategies here, and we're not going to go into detail on all the different types of tax-loss harvesting, but certainly this is a way that we can look at managing when we're paying taxes in different types of years.

We can also look at this—one of the strategies is looking at specific tax alphas that we can generate from these particular strategies. So it's another lever that we can pull in terms of what is the specific client situation, what is the outcome they're trying to drive towards, and can we start to generate some losses potentially in years to manage when and how we're paying the taxes on those gains. And not just blindly holding a security until the end outcome where we actually want to sell it and just saying, "Oh, there are the gains." We can actually manage through that process.

Phil: Okay, we talked about tax overlay. How is that different from tax transitioning?

Thomas: So they're very similar processes. The overlay we spoke about is an existing portfolio that we have. So Client A has come in. We have invested a portfolio for them. We are managing this tax budget on a year-to-year basis to make sure that we are driving for the outcomes that they want.

Tax transition uses the same logic, but it's helping our clients who have not yet transitioned their accounts when they have decided to become a client of ours. Think about this. We could have a client who says, "Yes, we would love to work with First Citizens Bank. But, Thomas, I've got a large amount of gains embedded in my existing portfolio. So coming over to you guys—even though I believe in what you're doing, I love your strategy, I want all your services, your solutions, your advice—but I don't want you to sell out of any of my positions because that would incur a massive gain right now, and I don't want to take that tax hit."

We totally empathize with that situation. It is hard to come over to a place, even if this is the advisors and the bank that you want to be with, it is very hard to say, "I'm going to do all of this while taking a really large hit in a tax payment in that given year." Similar to the overlay strategy, we have the ability to look at the existing positions that a client has, look at what our recommended portfolio that we would invest for this particular client, and we develop a very thoughtful strategy on how do we transition from that existing portfolio to the future ideal portfolio while managing through a clients' specific budget and making sure that we're able to get there over the course of many years, mitigating that entire transition and that entire process.

So it's a really, it's an easy way of saying we can manage it while you're here, and we can manage it while you're trying to get here as well—thoughtful across the entire spectrum.

Phil: That's great, Thomas, really appreciate your time today. I mean, I think the takeaway is there's a lot of strategies that we can tackle. Taxes are not—if you have embedded gains, that's a good thing. Sometimes, you know, taxes are a good problem to have, but the degree with which we can mitigate those is a real positive for clients and for that total return of their portfolio.

Thomas: Yeah, that's absolutely right, Phil. We want to drive client outcomes, positive client outcomes, and we want to make sure that we're doing it while we're thinking about the tax impact of them. Because it's really easy to just invest and see that X percent return that we're getting on our portfolios year over year.

And at the end of the day, though, we have to—it's not X. It's X minus something. And so we want to make sure that we're making the right choices and the right decisions to make sure that we continue to get the outcomes that we want for our particular clients. It can get tricky, but it's worth the process.

Phil: Well, thanks again, Thomas. And everyone, thank you for joining us. We look forward to next time.

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