It’s Not What You Make

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Ms. Green and Mr. Orange are comparing their investment portfolios.  Both started 20 years ago with $1 million in savings, let their assets grow for 10 years, then withdrew $150,000 (plus associated taxes) annually until today.  Amazingly, they both got the same pre-tax returns on their investments and had the same investment expenses.  Although their situations have been virtually identical, their ending portfolio values are quite different, as shown in the chart below.

ItsNotWhatYouMake-ItsWhatYouKeep-graphic_small

Why the substantial difference? TAXES.

Ms. Green works with an advisor who focuses on long-term after-tax returns.  Mr. Orange’s advisor cannot be bothered and does not pay attention to such details.  While it is true that the Green/Orange portfolio values will end up closer in the real world (perfect tax efficiency is not really possible), Ms. Green is thrilled that her advisor is paying attention to these details.

So what does Tarbox do to build tax efficient portfolios?

  1. We widely use index funds and ETFs.  These core holdings have a number of advantages, one of which is incredible tax efficiency.  In fact, the core ETFs we’ve used for the last 15 years have never had an annual capital gains distribution so gains on these holdings stay in client accounts.
  2. We pay attention to tax implications of every trade we make.  Our investment team makes investment decisions first (“let’s sell XYZ and buy ABC”), then looks at the tax implications for each client portfolio.  In some cases, the tax implications are big enough to change/delay/extend the trading plan.
  3. We build an appropriate fixed income portfolio.  While double tax-free bonds are great, they might not be the optimum choice in every client’s portfolio.  We review the “taxable vs. tax-free bond” decision frequently and will make changes if a client’s expected tax situation should change.
  4. We are long-term investors.  Long-term gains are taxed at rates substantially lower than short-term gains.  Rapid and short-term trading requires gains to be almost twice as high just to make up for the extra taxation.  Our longer-term market views (“three year view not three month view”) leads to long-term, not short-term, gains.
  5. We use “asset location” to help control taxes.  Thinking about a client’s entire investment portfolio (as opposed to several individually managed accounts) allows us to put tax generating holdings in the right accounts.  For example, we might purchase higher yielding holdings, like REITS or emerging market debt, in an IRA to reduce annual tax liabilities.

Paying attention to these details requires more resources/thought and quantifying the long-term value of these techniques is extremely difficult.  But, we do know there is value in our tax-efficient approach.

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