Tax mitigation strategies

Your portfolio is an important engine of your wealth. In light of this year’s market volatility, inflation and the potential for a recession, maximizing total after-tax returns is more critical than ever. In this Q&A with Dr. Wei-Yin Hu, vice president of financial research and strategy at Edelman Financial Engines, we discuss how we help our client portfolios build wealth in taxable accounts through tax-mitigating strategies.

 
Q: The markets have been quite volatile. Amid that volatility, you might be lured by dividend-paying stocks in the hope of getting more dependable returns, but those dividends are taxed. How do we seek to mitigate those taxes? 

Wei-Yin Hu:
Let’s first talk about the outcomes we seek for our clients. Our portfolios are designed to help build our clients’ wealth over the long term and through retirement. To do that, we seek to maximize total after-tax returns, especially in taxable accounts. That means evaluating each investment’s potential tax impact in addition to its risk/return profile and ability to enhance a portfolio’s diversification. Dividend-paying stocks should be a component of most diversified portfolios, but we also want to hold nondividend-paying stocks to help maintain effective diversification. That diversification is critical in helping a portfolio navigate a range of markets, so it can deliver expected returns over the long term. 

Dividend income can help provide a steady component of returns, but it is taxed. We want our clients to have control over their tax rates. It might be tempting to remove that investment if our clients have to pay material taxes on dividend income. But taxes are not the only lens. We don’t want to avoid high-dividend yields entirely due to taxes, nor is income our only criterion. With our taxable accounts, we’re balancing taxes against required diversification. 

Q: What about tax-exempt municipal bonds? They generate income without a tax hit. 

Wei-Yin Hu:
We do have exposure to muni bonds when their tax-exempt yield compares well to the after-tax yield of regular taxable bonds. But we won’t sacrifice diversification, which requires exposure to a variety of bond types. 

Q: Tell us about tax mitigation strategies that are specific to certain market conditions. For example, if it’s a taxable account, there’s tax-loss harvesting in a declining market. 

Wei-Yin Hu:
Tax-loss harvesting means selling investments below the original purchase price and replacing them with similar investments. The losses can be used to offset capital gain taxes or even ordinary income up to a certain limit. 

We can harvest tax losses for different kinds of investments, but it’s not something we do lightly as we need to find a security to replace another being sold. That said, we implement tax-loss harvesting when it can benefit our clients. 

Q: If you're a high-net-worth individual, you likely have substantial retirement savings in tax-deferred accounts like your 401k and IRAs. When you start withdrawing from these accounts in retirement, you'll owe income tax on those distributions. How can you avoid that potentially significant tax liability?

Wei-Yin Hu:
To navigate this, consider a diversified tax strategy that includes a mix of tax-deferred, tax-free and taxable accounts. Edelman Financial Engines can help clients who are within five years of retirement or already retired with a tax-efficient drawdown approach,* which optimally aims to maximize your after-tax wealth by strategically making upfront tax payments. This can help you optimize your tax situation in retirement and potentially reduce your overall tax burden.

Q: Edelman Financial Engines also provides customized portfolios, which employ tax mitigation strategies that are specifically tailored to a client’s unique tax needs. Tell us more about that. 

Wei-Yin Hu:
One way that customized portfolios can provide another level of tax efficiency is during rebalancing. We won’t necessarily go back to your original allocation but may adjust the allocations to mitigate capital gains or to take advantage of losses. 

Another tax mitigation strategy we employ in customized portfolios – both for taxable and tax-deferred – is called asset location. This means placing investments in taxable accounts or tax-deferred accounts depending on their tax profiles. For example, with stocks, we’ll look at putting relatively lightly taxed U.S. stocks in taxable accounts, while relatively tax-heavy international stocks would be concentrated more in tax-deferred accounts. 

Our methodologies for these strategies are patented.  Not all clients require this level of customization given their tax situations.  Either way, tax strategies are integrated into the investment management of our taxable portfolios.

*Contact a planner for more information to see if a tax-efficient drawdown approach is right for you. Certain limitations may apply.