Tax

Portfolio trading and taxes

Dec 04, 2023

Key takeaways:

Consider the entire cost profile of potential trade opportunities, including the execution cost and the tax cost.
When trading one position for another, choosing tax-efficient allocations and vehicles can have a high impact on after-tax returns.
When transitioning a whole portfolio to a target allocation, prioritize trades by their cost and portfolio impact.
You can make taxes less painful for your clients by harvesting tax losses, rebalancing through cash flows, and donating low cost-basis securities.

You work hard to meet your clients’ goals while taxes eat away at the rewards. And the bigger the tax bill, the more difficult the conversation with your client. Trade decisions can drive you into analysis paralysis, or make you want to pretend that taxes don’t even exist. But all you really need is an efficient framework for evaluating and implementing transactions within the context of taxes.

Is the trade worth its cost?

You’ve identified a potential trade opportunity for your client. You’ve analyzed it within the context of risk, return and portfolio outcomes and the prospects look rewarding. But will the trade still be beneficial after the cost of implementing it?

The cost of making a trade is straightforward. It is simply the execution cost (e.g., commission, trading spread) on each side of the trade plus the tax cost, as determined by your client’s tax rate applied to the capital gain on the position you sell.

The benefits of a trade may include lower costs, such as a lower expense ratio or fewer taxable distributions, as well as better performance, which requires some forecasting.

Sometimes costs can cancel out or even exceed the expected benefits of a position change. Unless there are unique circumstances that make the cost less important, such a trade would not be in your client’s best interest.

However, in many cases, the benefits of a trade can quickly add up to overcome the impact of taxes. Consider a hypothetical trade of a $100,000 position in Fund A for Fund B, where Fund A has a 25% long-term gain, resulting in a tax cost of $5,950.¹ As illustrated in the table below, the sum of the benefits achieved in just the first year after upgrading to Fund B outweigh the tax cost of the trade. (Since the cost of execution is often negligible for advisor- traded portfolios, we limit this discussion to capital gains tax costs.)

Be aware that the embedded (unrealized) capital gain on a fund position isn’t always as high as its total return might imply because total returns include previous distributions of income and gains. The higher a fund’s historical distributions, the lower a fund’s current embedded gain.

Make sure the benefits outweigh the tax impact
Hypothetical $100,000 trade of Fund A for Fund B

Hypothetical data for illustrative purposes only.

Implement the transaction to your client’s satisfaction

You’ve evaluated the trade and decided to proceed. You know the cost and, with a thoughtful transition plan, you can make it less painful for your client, whether you are trading just one position for another or transitioning the whole portfolio allocation. Keep in mind that managing taxes is not just about how you trade. It’s also what you trade. Choosing tax-efficient allocations and vehicles can have a high impact on after-tax returns.

The individual position trade

When you plan to trade one position for another, there are two ways you can make the tax bite easier for your client to swallow.

1) Harvest losses elsewhere in the portfolio
Making it a routine to evaluate positions with unrealized losses throughout the year can provide a cushion for taxable gains realized at a later date.

2) Split the transaction over two years
Be mindful of any changes to your client’s applicable tax rates or tax laws that may affect the outcome of this tactic.

The whole portfolio trade

If you’re transitioning a whole portfolio, make a list of the trades that will get you from the current to the target allocation and then follow these steps.

For illustrative purposes only.

1) Harvest low-hanging fruit
Sell positions with unrealized losses to soften the impact of taxes and execute trades that don’t require you to realize a gain.

2) Organize to prioritize
Organize the remaining trades based on tax cost and portfolio impact. High portfolio impact trades drive the portfolio’s asset allocation and its ability to meet objectives.

3) Exhaust your tax budget
Implement trades starting with the top priority bucket (low tax cost, high portfolio impact) and work your way down until you’ve incurred all of the tax costs that you are willing to bear.

4) Make a plan for the rest
For the remaining high portfolio impact trades, plan for their implementation over an acceptable time horizon that allows you to balance out tracking error with tax cost.
For the remaining low portfolio impact trades (fund upgrades), break up the transactions over time to allow for tax loss harvesting strategies that can offset some of the gains in the future.

To help make taxes less painful for your clients, you might consider evaluating positions with unrealized losses throughout the year, selling positions with unrealized losses, organizing trades based on tax cost and portfolio impact, maintaining a focus on tax loss harvesting, rebalancing through cash flows, donating low cost-basis securities, and implementing trades starting with the top priority bucket. Additionally, when managing a portfolio with very big gains, it’s important to consider the portfolio objective, tax sensitivity, and time horizon. By taking these factors into account, you can help your clients navigate the complexities of managing taxes on a portfolio with very big gains.

To make taxes less painful for your clients, you can maintain a focus on tax loss harvesting, rebalance through cash flows, and donate low cost-basis securities. By continuously seeking to harvest tax losses, you can reduce the sting of taxes when it comes time to realize gains. If a client is regularly adding cash, you can use it to selectively add to positions as a part of your rebalancing process, which reduces the need to sell positions. Capital gains taxes don’t apply when long-term appreciated securities are donated to charity, so you can use charitable giving as a means to reduce positions in a portfolio rebalance. To best serve your clients, keep tax management top-of-mind all the time ― not just at year end or when updating portfolio allocations.

A good tax discussion makes clients glad they hired you

In summary, it is crucial to consider the cost profile of potential trade opportunities, of which tax-efficient vehicles may meaningfully impact after-tax returns. Moreover, tax loss harvesting, rebalancing through cash flows, and donating low cost-basis securities are some of the key tools you can utilize to optimize your clients’ tax outcomes. Nobody likes paying taxes, but there are ways to initiate positive conversations with your clients. Consider reminding your clients that they wouldn’t be paying taxes if they hadn’t made money as well as highlighting some of the strategies you’ve used throughout the year to maximize their after-tax returns. The tax conversation is an opportunity to demonstrate your value as their advisor.