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A Guide to Tax Management

Posted by Gerard Michael on Aug 11, 2021


What is tax management? A simple guide. 



The basic idea of tax management is straightforward: reduce taxes without reducing pre-tax returns (or at least without reducing pre-tax returns more than you save in taxes). So far, so good. But what exactly does this mean and how is it done? We thought we’d break it down. So here it is, a guide to tax management.


The components of tax management

There are at least six tools in the basic tax management toolkit1:

  1. Short-term gains deferral (postponing the sale of a short-term position you might otherwise wish to sell until it is long-term)
    Long-term capital gains tax rates are lower than short-term rates (for federal taxes, up to 20% for the long term vs. up to 37% for the short term). Waiting to sell a short-term position until it becomes long term can cut your tax bill almost in half. 

  2. Long-term gains deferral (postponing the sale of long-term positions you might otherwise wish to sell)
    Even if you eventually do realize the gains, you will have postponed paying taxes, which you can view as an interest-free loan. If you postpone the sale until retirement, the gains may be subject to a lower tax rate. If you postpone the sale until death, you (or, more precisely, your estate) avoid the taxes completely.

  3. Loss harvesting (selling a security to realize a loss that can be used to offset gains from elsewhere in your portfolio and thereby lower your tax bill)
    No one likes having investments go down in value, but loss-harvesting is a way of getting something back. To learn more about tax-loss harvesting, see a blog post from our parent company, Smartleaf: Why Tax Loss Harvesting Really Matters.

  4. Tax budget (keeping taxes from net realized gains below a predetermined threshold)
    The two keys to implementing a tax budget well are 1) taking maximum advantage of tax-loss harvesting opportunities to give yourself freedom to realize more gains, and 2) optimizing how you spend your limited tax budget to get the biggest risk and return improvement for every tax dollar.

  5. Tax-efficient product selection (purchasing securities that won’t generate a lot of taxable income, either because the income is tax free or it takes the form of unrealized capital gains)
    Some securities are more tax efficient than others. Interest from corporate bonds is taxed as ordinary income. The returns of some actively managed mutual funds take the form of short-term capital gains distributions. On the other hand, municipal bonds are tax free (though they also pay a lower interest rate). And index products, especially ETFs, tend to generate low capital gains distributions.

  6. Tax-efficient Householding (holistically managing a group of accounts (e.g., 401Ks, taxable accounts, IRAs, etc.) belonging to a single investor or household in a manner that reduces taxes)
    There are two main householding tax management techniques:
    1. Tax-optimized account selection for asset-class rebalancing: rebalancing in tax deferred accounts in order to avoid capital gains taxes. 
    2. Tax-optimized asset location for purchases: placing (i.e. purchasing) the least tax efficient securities (e.g., bonds, hedge funds) in tax-deferred accounts. (Note, however, that there can be a tension between concentrating tax-inefficient securities in tax-deferred accounts and being able to rebalance at the asset class level-efficient manner.) 


The challenges of tax management

Listing tax management techniques is fairly easy. Actually implementing them can be hard. Here’s a sample of the issues involved:

  1. Trade-offs
    The biggest challenge of tax management is handling trade-offs. While reducing taxes is important, so is reducing costs and maintaining the desired risk and return characteristic of the portfolio. These goals will often conflict, so tax management involves a balancing act. It’s an optimization problem, which is why all sophisticated tax management programs are optimization based. Simple rules (e.g., “never sell positions with short term gains”) aren’t up to the task of handling trade-offs. Making the rules more complicated (e.g., “never sell positions with short term gains unless they are ranked “sell” or the gain is less than $10 or there is a cash withdrawal or the asset class is overweighted”) becomes unworkably complicated and unwieldy.

  2. Tax budgets
    Tax budgets present their own optimization problem. If you’ve got a limited tax budget, how should you spend it? Use it all to help draw down a concentrated position? Use it to get asset classes closer to their target weights? Some combination of the two?

  3. Loss harvesting
    Loss harvesting is more complicated than just selling securities at a loss. You obviously don’t want to tax-loss harvest unless the tax savings more than cover the extra trading costs. But by how much? The answer requires its own form of optimization. An optimal tax loss harvesting strategy depends on 1) the investor’s tax rates, 2) the transaction costs, 3) the stocks volatility, 4) the time till the lot is long term (if it’s currently short term), and 5) the time to year end.

These are the basics of tax management. It was once a largely manual process, so it was only offered to high net worth investors. That is changing. Tax management is now automatable, and we’re seeing the type of tax management that was once the exclusive preserve of ultra high net worth investors being offered to all investors.


SAM and tax management: tax management is central to SAM’s services, and we currently support short-term gains deferral, long-term gains deferral, loss harvesting, and tax budgets (SAM support for householding is forthcoming). We consider ourselves part of a larger trend to lower the cost and broaden the availability of leading portfolio management practices. And, we’re only getting started. 

1This list excludes complex tax management strategies that rely on tax shelters, swaps, futures, options and the like. That’s a whole separate topic.

Gerard Michael
Gerard Michael

President, Co-Founder