Improving tax efficiency in client portfolios

There is an old investment adage that states it is not how much you earn but how much you get to keep.

Poor tax planning can be one of the most significant reasons why investors are often disappointed with what they get to keep. Sometimes the problem is simply failing to take advantage of common-sense tax minimizing strategies. Perhaps more surprisingly, we frequently encounter portfolios where too excessive a focus on avoiding making any tax payments distorts investment decision-making and unnecessarily limits returns.

At Boston Trust Walden, we consider many factors in promoting tax efficiency in client portfolios – an approach that is inclusive of but extends beyond the more obvious methods of low turnover, tax loss harvesting, and buying municipal bonds. The fundamental attractiveness of the securities one owns, the account structure within which those securities are located, and adherence to a sound cash flow strategy are also critical.

Boston Trust Walden’s investment process is designed to structure broadly diversified portfolios of high quality, reasonably valued securities. Because we take a long-term perspective when we consider an investment, we seek companies with stable financial results and business models that can be sustained far into the future. This approach helps shield client portfolios from generating the costly short-term capital gains that can result from frequent trading in the pursuit of quick profits. We have also found that certain investment products and strategies – partnerships and hedge funds among them – are generally less tax efficient. At the very least, they add an incremental layer of complexity (and therefore expense) to tax return preparation. For that reason and others, we tend to avoid using them as building blocks for client portfolios.

Tax efficiency is not only predicated on what you invest in but also where you invest. Strategically placing assets in the right type of account matters. That is because tax authorities treat certain investments and certain account types differently. We cannot control the Internal Revenue Code, but we can avoid paying an unnecessary levy by considering marginal income tax rates, investment time horizon, liquidity needs, and tax deferral options when determining how to allocate specific investments to retirement, non-retirement, or charitable purpose accounts.

Working with clients to understand liquidity needs and mapping out a schedule of anticipated distributions is another tool to support tax efficiency. Our team establishes a dialogue with our clients’ tax professionals to understand the nuances of their individual circumstances, whether it be an income threshold at which they would become subject to a different marginal rate or the availability of tax loss carryforwards.

Finally, we view it as a fiduciary imperative to strike an appropriate balance between the pure fundamental merits of an investment decision and its tax implications. Said differently, one must be careful not to let the tax tail wag the investment dog.

By partnering with our clients’ tax professionals to gain a more complete understanding of their tax picture and then incorporating these strategies when developing a customized investment plan, we believe we can improve upon the investment returns that really matter to our clients, that is the after-tax, after-expense, risk-adjusted returns.