December 3rd, 2014 | by

The Art and Science of Investing in the Presence of Taxes

Here we are in December, when one of the rites for many investors each year seems to be to suddenly awaken to possible year-end tax moves. Perhaps your accountant has rung to discuss which portfolio positions to sell for tax reasons. The financial press is replete with versions of “smart year-end tax strategy” articles. This is all well and good, but in this column I want to make the case that: a) investors should pay attention to tax strategies such as tax-loss harvesting during the entire calendar year, and b) investors should do a much better job of integrating their taxes and Form 1040 with their investment portfolio strategies.

I grew up immersed in taxes (my family had a tax-accounting business), and I have reviewed thousands of tax returns and also advised countless clients on investing for more than 20 years. One thing that continually strikes me is how people tend to compartmentalize their financial lives, separating their tax returns from their investment portfolios. In behavioral finance this disconnect is called mental accounting. Investors need to recognize that taxes and adroit tax management are key considerations when formulating and executing an investment strategy.

It’s What You Keep That Counts

One basic issue is that investors should focus more on their after-tax return; for taxable investors, how much an investment earns matters less than how much of that return they actually keep after taxes. You can think of it this way: unlike inflation, interest rates, market gyrations, or the returns of individual securities or active fund managers, the taxes you pay on investment gains are one aspect of investing over which you can exercise a considerable degree of control.

We can quantify the importance of adept tax management in investing. Research by Gerstein Fisher and others (for example, see Past Performance is Indicative of Future Beliefs) shows that investors typically surrender one to two percentage points of investment returns to taxes each year—which quickly adds up when compounded over a 30-year investment horizon. We believe that skillful, active tax management can add back 0.5-1 percentage points to after-tax portfolio returns each year (remember that the benefits are greater for taxpayers in higher tax brackets).

The exhibit below depicts one scenario. I calculated a popular US stock index fund’s pre-tax and after-tax returns from September 1, 1976 to December 31, 2013, using a 40% tax assumption for income and 25% for capital gains. Bear in mind that investing in index funds is one of the most tax-efficient strategies out there for stock investors. Even so, on a pre-tax basis, a $100,000 investment in the index fund compounded at 11.04% a year, multiplying to a $4.99 million terminal value, but only at 9.53% for an ending balance of $2.99 million on an after-tax basis. In sum, income taxes subtracted 1.5 points of investment gains per year and reduced gains by 40%, or $2 million. An investor can reduce those losses to taxes through skilled tax management at the portfolio level.

The Tax Drag
Using the 1040 to your advantage

The first step in marrying taxes and investments should be a line-by-line analysis of your Form 1040. Turning over your 1040 to a CPA is no excuse for failing to analyze this valuable document for clues to better investing—he or she is typically not analyzing the form with an eye to active tax management or ruminating over the investment implications of your tax situation. Every one of the 77 lines on the Form 1040 (many of them summaries of statements, such as Schedule B or D) is an excerpt from your financial story and a potential roadmap to more-efficient investing. For some details on how to approach interest and dividend earnings, please see my previous column Using The 1040 To Build Wealth.  But I want to make special mention of tax-loss harvesting (TLH), which relates to capital losses and gains (line 13 on the 1040).

This discipline—the practice of selling securities in the portfolio at a loss and applying those losses to offset realized taxable gains (including gains on the sale of a property or business)— increases the amount of net-of-tax money available for investment and should be practiced throughout the year (not just at year-end) when opportunities present themselves.

One way of approaching TLH is as an opportunity to embrace market volatility and to share your losses with the government. With no control over market movements, an investor needs to be opportunistic during the year to maximize the benefit of tax-loss harvesting. For instance, in 2014 from early September the Russell 2000 Index of small-company stocks swooned for about six weeks and at one point was down more than 10% year-to-date. That was a chance to recognize a loss for tax purposes, but that window closed rather quickly when small caps came roaring back through the fall. International developed stocks, foreign bonds and commodities, all of which have suffered in 2014 due in part to dollar strength, have also presented nice opportunities for tax-loss harvesting (TLH works best when applied to a multiple-class portfolio with asset classes that move out of synch).

There is more than one tax-loss harvesting strategy, but here is one method to consider (for more insight into our thinking, see Building a More Tax-Efficient Portfolio – The Gerstein Fisher Tax-Managed Equity Strategy). Let’s say you have a diversified portfolio of stocks with careful thought given to risk exposures. You want to maintain those risk exposures while the reaping the tax-loss harvest. You can sell stock A with an embedded capital loss and immediately purchase stock B, an equivalent stock in the same industry with the same risk and return characteristics (note that, due to wash-sale rules, you cannot repurchase stock A for more than 30 days). We call this method characteristic matching.

Here’s a simple example of the math. Let’s say you made a $100,000 investment that is now worth $80,000 and you’re in the 35% tax bracket. If you sell and realize the $20,000 loss, you can reinvest $87,000 ($80,000 proceeds + (.35 x $20,000)). In effect, the government is extending you an interest-free loan to invest long term.

Taxes are obviously an important but complex area of investing, but one in which a skillful and disciplined financial advisor can add significant value to an investment portfolio year in and year out.


Too many investors fail to link their tax documents with their investment portfolios. This creates portfolio inefficiency and reduces long-term investment returns. I suggest that investors make year-round tax management one of their New Year’s resolutions for 2015.

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