When we think of taxes and tax management, the basic idea is straightforward, reduce taxes without reducing pre-tax returns (or at least without reducing pre-tax returns more than you save in taxes). If that’s not too clear, here is a guide to the key points to understand when it comes to tax management:

Short-term gains deferral: Holding off on the sale of a short-term position that you might otherwise wish to sell, until the position has become long-term (which therefore allows it to be subject to the lower long-term capital gains tax rate).

Long-term gains deferral: Delaying the sale of long-term positions you might otherwise wish to sell. Even if you 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) avoids the taxes completely.

Loss harvesting: Disposing of a security at a loss, in order to realize a loss that can be used to lower your tax bill.

Tax budget: Keeping taxes (or just taxes from realized gains) below a predetermined threshold. When implementing a tax budget : 1) take maximum advantage of tax-loss harvesting opportunities to “buy” yourself freedom to realize more gains, and 2) optimize how you use your limited tax budget to get the biggest return improvement for every tax dollar.

Tax-efficient product selection: Purchasing securities that won’t generate a lot of taxable income because either the income is tax free or it takes the form of unrealized capital gains. Some securities are more tax efficient than others. Interest from bonds are 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). Index products, especially ETFs, tend to create low capital gain distributions.

Householding: Generally controlling a group of accounts (e.g. 401Ks, taxable accounts, IRAs, etc.) that belongs to a single investor or household in a manner that will help to reduce their taxes. There are three main householding tax management techniques:

Householding – tax-optimized account section for asset class rebalancing:

Sifting through and figuring which accounts to sell over weighted asset classes, so as to minimize taxes. Firstly you have to realize the losses in taxable accounts; your second choice is to sell gains in tax-deferred accounts (like 401Ks); your third choice is to sell gains in taxable accounts (and if you have more than one taxable account, to sell in the accounts with the least gains).

  1. Householding – tax-optimized asset location for purchases:

Buying your 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 re-balance at the asset class level in a tax-efficient manner.)

  1. Householding – tax-optimized account selection for withdrawals:

Selecting the right accounts from which to withdraw funds, in order to minimize taxes and other costs. Here, you need to consider not just tax impact, but rules governing withdrawals from tax-deferred accounts—there can be penalties for both early withdrawals and “late withdrawals” (i.e., not taking required minimum distributions).


The Challenges of Tax Management

Listing tax management techniques is fairly easy. Actually implementing them can be hard. We could go on about this at some length, but we’ve learned that not everyone is as interested in this stuff as we are. So here’s a sample of the issues involved:

  • Trade-offs

The biggest challenge is handling trade-offs. While reducing taxes is important, so is reducing costs and maintaining the desired risk and return characteristic of the portfolio. Goals such as these will often conflict, so tax management involves a balancing act. Easy rules (e.g., “never sell positions with short term gains”) aren’t up to the task of handling trade-offs, causing the rules to be 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 over weighted”) becomes complicated and unwieldy.

  • Tax budgets

Tax budgets present their own issues. If you’ve got a limited tax budget, you could either use it all to help draw down a concentrated position, or use it to get asset classes closer to their target weights. Let’s figure even a combination of the both.

  • Loss harvesting

In getting the most out of loss harvesting, you don’t want to lose harvest unless the tax savings will more than cover the extra trading costs.  An optimal tax loss harvesting strategy depends on either: 1) the investor’s tax rates, 2) the transaction costs, 3) the stocks volatility, 4) the time it will take for the lot to become long term (if it’s currently short term), and 5) the time till year end.

The good news as we approach tax day, is that there are accounting corporations that specializes in tax management, such as Axio Accounting & Tax, that makes it easy for such concerns to be handled, with seamlessly no trouble at all, and all our tax evasion fears will never come to reality.