Optimize U.S. taxable portfolios by understanding capital gains taxes and using tax-smart strategies to seek enhanced after-tax returns.
In brief
- Understanding the drivers and impact of taxes is a critical step in mitigating their impact on client portfolios.
- Technology-driven tax-smart investing has the potential to benefit investors and help them keep more of what their portfolios earn.
Portfolio decisions can, and often should, vary significantly based on individual investor objectives and personal circumstances. However, for taxable portfolios in the U.S., understanding the impact of capital gains taxes is an essential first step in narrowing the gap between what portfolios return and what investors get to spend.
Understanding capital gains basics
From Banksy to Basquiat, Beanie Babies to baseball cards, and from Buffett to Bogle, what’s bought is sometimes later sold for more than what was paid for it. Capital gains are simply the profits from the sale of an asset that has increased in price. That price increase could be the result of inflation, fashion, interest rates, or revenue. The gain could be several dollars or much more.
For all assets, it’s the sale itself, and not any prior unrealized “on paper” gain, that typically triggers the tax liability.* And when profits are made, taxes often closely follow. For investors in stocks, bonds, and other financial assets, the core concept remains the same. Nevertheless, the regulations on how and when realized gains are taxed warrant analysis. Informed investors can then make informed decisions and take steps to reduce the cost of realized gains.
Cost Basis |
Cost basis is simply the original purchase price of an asset.** For investments, it is typically adjusted to reflect stock splits, dividends, capital distributions, and transaction fees. The difference between the sale price and cost basis is the capital gain and is subject to taxation. |
Unrealized capital gain |
An unrealized capital gain refers to the increase in value of an asset that is owned but has not been sold. Typically not subject to taxation, unrealized gains exist on paper and have not been converted to cash through a sale. |
Short-term and long-term capital gains |
Short-term and long-term capital gains differ in treatment. It’s an impactful distinction. For stocks and bonds owned for less than a year, profits are treated as if they were ordinary income and are taxed with the same marginal tax brackets and at the same rate as other income. For securities owned for more than a year, long-term rates apply. Currently, these rates are distinct from and lower than those that apply to ordinary income. All other things being equal, today it can pay to hold investments for more than one year. |
Wash sale |
Wash sales occur when a security is sold at a realized loss and a substantially similar security is then bought within 30 days. The term “substantially similar” is used by the IRS, and the details are important. If an investor sold the stock of, say, a chip manufacturer and within 30 days bought the stock of a different chip maker, the wash sale rule wouldn’t apply. The companies may be similar in focus, but that’s not a violation. The IRS would, however, consider it a violation should our investor buy back the same stock within 30 days. Similar principles apply with mutual funds. For example, two large-cap equity funds that track different indices would not be considered substantially similar. |
Tracking error |
Tracking error measures the differences, both positive and negative, in performance between a portfolio and its benchmark. It can be measured historically using realized returns or, as J.P. Morgan does, estimated on a forward-looking basis. This method (also called ex-ante) predicts how different a portfolio’s returns might be from its benchmark due to differences in current positioning. |
And don’t forget the impact of state-specific capital gains regulations. Currently, eight states*** have no capital gains (or income) tax, while others offer exclusions and deductions. It’s important to appreciate that today’s tax rates and regulations may not be tomorrow’s, so it’s always wise to discuss investment taxes with your advisor and accountant.
“Cap gains” versus capital gains: Two scenarios
Advisors and investors alike have to balance investment decisions with the total potential benefit and total potential cost of those decisions. The impact of taxes is important (and, of course, actionable), but not so important that investment strategy is unduly impacted. Legacy positions may incur a tax bill if sold, but the portfolio impact of not selling could also come at a cost. While tax impact may be secondary to broader client objectives, additional analysis can provide additional benefits to after-tax returns. Along with the holding period, how investments are structured and where buy-sell decisions are made also have an impact that should be fully understood. There are two scenarios.
1. The (navigable) challenges of active management
Active investment decisions intended to improve risk, return, and investor outcomes tend to come with potentially costly capital gain externalities. This is true whether an investment strategy is delivered in an active mutual fund, SMA, or model portfolio—although gains can manifest themselves differently across investment vehicles. While gains stemming from active management are generally unavoidable, they present an opportunity for tax management to complement the investment process by lessening the impact of gains via ongoing tax-loss harvesting.
Examples:
- Professionally managed mutual funds remain a valuable way for investors to access a wide array of investment managers and strategies. However, whether individually or as a component in a model portfolio, their structural tax inefficiencies can create expensive and poorly timed tax bills.
- Actively managed SMAs can create capital gains as a manager turns over the portfolio to realize gains on winning positions, reallocate exposures, etc.
- Model portfolios can result in capital gains for investors as model managers reallocate target holdings to manage risk, seize tactical opportunities, or realign with long-term outlook changes. Each of these actions may be designed to benefit the investor but could realize gains that have the opposite effect.
- In all the above scenarios, the investors themselves haven’t changed anything (and they may not have even been an investor when the underlying asset gained in price), yet a bill is due. Therein lies the opportunity for active tax management to complement active investment management.
2. Mitigating “controllable” gains with tax-smart management
At the market, fund, and security level, investment losses ebb and flow quickly. Tax-loss harvesting was once limited to only larger accounts and occasional use (typically near year-end), restricting utilization and effectiveness. The constant oversight required and costs of trading were prohibitive otherwise. Today, the advancement of automated tax-loss harvesting has expanded the scope and improved the effectiveness of tax-smart investing across wealth accumulation, spending, and portfolio transitions.
By continually monitoring price fluctuations of markets and client holdings, automated tax-loss harvesting has the potential to reduce the impact of capital gains on portfolios. With a tax-smart strategy and today’s technology, investors and their advisors can see the full tax impact of their transactions and manage accordingly. Information is indeed power.
Getting to better after-tax outcomes
So, what should a concerned investor do? Today, tax-savvy advisors can utilize technology and a range of solutions and strategies designed specifically to add a layer of control and reduce the impact of capital gains taxes for their clients.
The inherent structure of ETFs can help active investors insulate themselves from gains embedded in mutual funds. When combined with tax-smart management, the direct security ownership structure of SMAs can pair gains with losses to deliver improved after-tax outcomes. Similarly, tax-smart approaches to implementing and managing model portfolios can evaluate sleeve-level gains and losses to help reduce overall gains and tax liability.
As we’re fond of saying, it’s not what you make that matters, but what you keep. We’ll write more about how advisors can use and discuss tax-smart technology and strategies with their clients in our upcoming blogs. J.P. Morgan is committed to being the industry standard for tax-smart solutions and insights.
* TIPS adjust their principle based on CPI. These adjustments are taxed in the year that they occur.
** The cost basis of certain investments, including commercial real estate, can be adjusted.
*** Alaska; Florida; Nevada; New Hampshire; South Dakota; Tennessee; Texas; Wyoming.