Tax-aware investing

Taxes can reduce the amount of an investment return that a client ultimately keeps. Evaluating after-tax outcomes alongside investment performance, risk, fees, and expenses can help advisors identify opportunities to improve after-tax wealth. These opportunities may include managing capital gains distributions, selecting tax-aware investment vehicles, locating assets across account types, and harvesting eligible investment losses.

Tax-loss harvesting is the practice of selling an investment at a loss and using the realized capital loss to offset realized capital gains. If losses exceed gains, federal income tax rules may allow an investor to deduct a limited amount against ordinary income and carry unused losses forward, subject to applicable tax rules. 

Tax-loss harvesting is often considered throughout the year as part of ongoing tax-aware portfolio management. Investors and advisors should also consider transaction costs, portfolio exposure, holding periods, and the wash-sale rule before implementing the strategy.

Because determining whether investments are substantially identical can be complex, advisors should evaluate potential replacement investments carefully and encourage clients to consult a tax professional regarding their individual circumstances.

The wash-sale rule generally disallows a current tax deduction for a loss if an investor buys the same or a substantially identical security within 30 days before or after the sale. The disallowed loss is generally added to the cost basis of the replacement security, although different treatment may apply in certain accounts or circumstances.

Because determining whether investments are substantially identical can be complex, advisors should evaluate potential replacement investments carefully and encourage clients to consult a tax professional regarding their individual circumstances.

A fund’s tax efficiency may be influenced by its structure, investment strategy, asset class, portfolio turnover, trading activity, shareholder cash flows, and distribution history. ETFs may offer structural tax efficiencies relative to mutual funds, including the potential to reduce the realization of capital gains through in-kind creation and redemption activity. However, tax outcomes vary by fund and are not guaranteed.

When comparing funds, advisors can consider estimated capital gains distributions, historical distributions, turnover, unrealized gains, investment strategy, fees, risk, and overall portfolio fit.

Price return measures the change in an investment’s market value. Total return includes both price return and income, such as dividends, interest, and capital gains distributions.

The distinction can matter when reviewing a portfolio for potential tax-loss harvesting opportunities. An investment may have a positive total return because of distributions while still having a negative price return. Because gain or loss for tax purposes generally depends on an investor’s adjusted cost basis and sale proceeds, negative price return can be a useful screening signal, but it does not by itself establish that an investor has a tax loss.

Asset allocation determines how a portfolio is divided among investments such as stocks, bonds, and cash. Asset location determines which account types, such as taxable, tax-deferred, or tax-exempt accounts, hold those investments. Locating less tax-efficient investments in tax-advantaged accounts may help reduce current tax exposure, while more tax-efficient investments may be appropriate for taxable accounts. The appropriate approach depends on a client’s objectives, time horizon, liquidity needs, tax situation, account restrictions, fees, and other individual circumstances.

The Tax Evaluator helps financial advisors screen eligible portfolio holdings for estimated capital gains distributions and funds with negative price returns that may warrant further review. These insights can help advisors identify holdings with potential tax exposure and begin conversations about fund selection, portfolio transitions, and possible tax-loss harvesting opportunities.

The results are estimates and screening indicators. They do not reflect an individual investor’s adjusted cost basis, transaction history, holding period, tax rate, or complete tax circumstances. Advisors should evaluate the results alongside the client’s portfolio objectives and encourage clients to consult appropriate tax professionals when needed.

Because tax rates and contribution limits may change, advisors should consult the current Tax Guide for Investment Decisions and Contribution Limits and Tax Reference Guide. State and local tax rules may differ, and clients should consult a qualified tax professional regarding their individual circumstances.