Strong returns from an investment portfolio are generally a cause for celebration. But when it’s time to take profits, realized investment gains may trigger capital gains taxes that can dampen the mood.

Using a tax-management strategy can reduce an investor’s tax bill; however, the process can be complex and has historically been cumbersome and time consuming.

Intelligent tax-savings technology is changing the economics by providing customized, continual tax analysis and effortless tax-loss harvesting in investor portfolios. Minimizing taxes and maintaining market exposure may help investors maximize returns. And, saving time on tax-management administration allows advisors to focus on client relationships and grow their business.

Taxes can meaningfully impact investment returns

Investors spend a lot of time thinking about their financial goals, determining an optimal asset allocation and selecting investment strategies. Taxes are often an afterthought or a last-minute, year-end consideration.

It’s understandable that no one wants to think about paying taxes – but this may come at a cost. After all, what counts more than a portfolio’s return is what you keep after taxes.

Taxes on both long- and short-term capital gains in taxable accounts can reduce overall investment returns. For example, an investor with $100,000 in realized gains would only receive $76,200 after paying $23,800 in taxes, assuming a 23.8% long-term capital gains tax rate (with short-term capital gains taxed at a higher rate).

In addition to annual taxes on portfolio returns, some common situations may trigger meaningful capital gains taxes that impact total investment performance. For instance, when investors change advisors or fund a new separately managed account (SMA), transitioning to the new portfolio holdings often involves selling some legacy or existing securities. This may result in large realized gains – and a tax bill to match – if the process is not carefully managed.

A poorly managed transition can negatively impact an investor’s near-term returns by incurring significant capital gains taxes. In the medium and longer term, if exited positions are not replaced, the loss of market exposure or drift from the intended allocation can cause a portfolio to lag.

Sometimes an investor is reluctant to realize gains and pay taxes, resulting in a portfolio that is no longer properly aligned with its investment strategy, putting future performance at risk until it is fully transitioned to its target state.

Another situation that can lead to a large tax bill is a concentrated position in a stock, which might occur when an individual has received company stock as compensation from an employer over many years. When the time comes to sell the shares – whether to diversify a portfolio or for living expenses in retirement – this can cause big realized gains and taxes.

Tax-management strategies seek to reduce taxes while maintaining investment goals

A widely used strategy to manage taxes in an investment portfolio is tax-loss harvesting. The strategy works by selling select holdings (for example, stocks or ETFs) that have decreased in value to realize losses in a portfolio and then using those losses to offset gains; this reduces the total capital gains tax that an investor has to pay and improves after-tax returns. To maintain the general investment strategy and market exposure of the portfolio, an investor typically buys securities that are similar to the ones that were sold. Tax-loss harvesting can be a potentially win-win situation, creating value from losses in a portfolio.

Tax-loss harvesting can meaningfully reduce taxes owed on capital gains

Hypothetical illustration using $100,000 in capital gains

Source: J.P. Morgan Asset Management. Assumes 23.8% capital gains tax. For illustrative purposes only.

This combination of reducing taxes and staying invested may improve after-tax returns each year, which compound over time to contribute to long-term wealth accumulation.

Not surprisingly, households with greater than $5 million in investable assets ranked tax management as their number one financial need. Yet 70% of “tax-managed” assets are not managed systematically, but rather, in an ad hoc manner.ⁱ

Tax management has often been complicated and time consuming

With so many benefits and strong interest from investors, why isn’t tax management more broadly and systematically used? Well, it’s complicated, literally, and when done manually, it has historically been costly in terms of time, potential errors or unintended changes in the portfolio’s exposure.

Some of the key issues around tax-management complexity include:

• Operational and administrative challenges: Tracking, record-keeping and reporting multiple tax lots, cost bases and holding periods can be complex, especially for investors with diversified portfolios.
• Compliance considerations: Wash sales rules require strict compliance that can make errors costly and limit the ability to reinvest proceeds of sales for tax-loss harvesting purposes.
• Tax laws: Varying tax laws or changes to regulations require additional diligence and can impact tax-loss harvesting benefits.
   

Tax-management strategies must also consider the potential impact to returns from:

• Market volatility: Timing sales correctly to optimize usable losses can be challenging in volatile markets.
• Transaction costs: Extra costs from tax-loss harvesting may chip away at the ultimate tax savings for individuals. 
• Portfolio distortion: Sales of select holdings for tax purposes could unintentionally distort a portfolio’s characteristics, change the asset allocation or increase concentration risk.

For advisors, the opportunity cost of spending time and effort on manual tax management is time that could be spent on investment management, client servicing and business development. Furthermore, maximizing the potential of tax-loss harvesting requires looking for opportunities throughout the year, not just at the end of the year, demanding even more time and effort.

An intelligent tax-management technology can save time and money

At J.P. Morgan Asset Management, we constantly look for ways to improve performance for clients, including through tax management. We’re well aware of the challenges investors and advisors face trying to efficiently manage taxes, which was a key motivation to build out the J.P. Morgan Tax-Smart Platform.

Our tax-savings technology offers continual tax analysis and effortless tax-loss harvesting – requiring no daily management and no manual monitoring – and simplifies portfolio transitions. 

Both investors and advisors can benefit from the J.P. Morgan Tax-Smart platform’s features, including:

• Oversight from a seasoned J.P. Morgan Asset Management portfolio manager, who can also help prioritize potential long-term investment gains in addition to tax savings
• Ongoing tax management – not just at year-end – that monitors holdings on a regular basis for opportunities to save on taxes all year round, while keeping your portfolio on track
• Customization, allowing you to tailor portfolios by restricting specific industry sectors, special categories and individual stocks
• Tax-Smart transitioning using a custom transition plan, minimizing the tax impact of moving securities to a new portfolio 
• Intelligent technology that allows you to provide efficient tax management for investor portfolios at scale by reducing the manual work
• Suite of Tax-Smart investment capabilities, including model portfolios, direct indexing SMAs and actively managed SMAs, helps you serve a wide range of client needs  

Case study: Tax-Smart technology may generate a substantial tax savings when changing a portfolio 

Hypothetical Illustration using $5 million in existing investments, with $1 million in unrealized gains

Source: J.P. Morgan Asset Management. One-time transfer assumes one-third of gains are short-term gains taxed at 40.8% and two-thirds are long-term gains taxed at 23.8%. For illustrative purposes only.

It’s important for investors to understand that tax management can play a big role in maximizing potential portfolio returns. When investors and advisors are choosing an appropriate asset allocation and investment strategy, consider adding tax-management strategies to the discussion. And while tax management has historically been costly in terms of time, potential errors or unintended changes in the portfolio’s exposure, our Tax-Smart technology can help investors save on taxes and maintain portfolio construction, while saving you time.

Learn more about our Tax-Smart Platform

ⁱSource: Cerulli Associates, The Case for Direct Indexing: Differentiation in a Competitive Marketplace, December 2022.isclosures

The impact of a tax-loss harvesting strategy depends upon a variety of conditions, including the actual gains and losses incurred on holdings and future tax rates. The results shown in these materials are for illustrative purposes only and do not represent actual investment decisions.

The tax-loss harvesting service is available for an additional advisory fee and the results shown represent the net effect of the advisory fees but may not consider the impact of fees charged by others, including transaction costs or other brokerage fees. The information contained herein is subject to change without notice, is not complete and does not contain certain material information about the investment strategy, including additional important disclosures and risk factors associated with such investment and information about fees, trading costs and taxes.