The Hypothetical Investor:
• 43 percent tax rate on interest income
• 43 percent tax rate on short-term capital gains
• 20 percent tax rate on long-term capital gains
Under these assumptions, the pre-tax return is 10.00 percent per annum, but the after-tax return falls to 5.70 percent
Let’s assume we could actively tax manage this account such that the following held true:
• The realization of capital gains are delayed by 3 years (for tax purposes)
• 65 percent of all capital gains are converted to long-term status
• Interest income is converted to municipal tax exempt interest
• But, as a consequence of the use of municipal bonds, the interest rate falls by one-third
The results of such an active tax management program increase the realized after-tax return by over 34 percent, from 5.70 percent to 7.65 percent. The serious question then becomes, are such active tax management benefits (a 34 percent improvement) both reasonable and achievable? I would argue the answer is, absolutely yes. But success will require the active combination of seven synergistic tax management techniques. Let me explain.
Tax minimization relies on three main strategies -- Delay, convert and replace:
DELAY. By delaying the realization of capital gains from a tax standpoint, it allows the investor to hang on to their money longer, gaining the benefit of growth over time. This benefit can be achieved through two techniques.
• First, employ active tax loss harvesting during the last two weeks of December each year.
• Second, make use of commingled trusts with existing embedded capital losses. This second technique is a new one; that is only now practical after some recent changes to the tax law. Previously, commingled vehicles such as mutual funds could only carry forward their embedded capital losses for a very short number of years, at which point any unused embedded losses were lost. But today, under the revised tax statutes, these embedded losses may be carried forward indefinitely.
CONVERT. By converting the recognition of capital gains from short-term to long-term, the investor’s tax bill is meaningfully reduced.
• This benefit can be achieved by adopting a year-and-a-day holding period for all investments. After suggesting this approach, I sometimes hear the question, “But if I hold my individual positions for a year-and-a-day, then don’t I have a passive investment instead of an active investment -- in effect forcing me to give up the benefits of active management?” Such a conclusion is obviously false. It confuses a rather important attribute of active management. The size of an active management bet is based on how far the portfolio has been positioned away from the passive benchmark -- and NOT on how frequently one changes their mind about what the bet should actually be (i.e., how frequently one trades).