When investors evaluate a portfolio, the conversation usually starts with returns. How much did the market make? How much did my portfolio make? Did I outperform or underperform?
Those are important questions. But they leave out another one that can matter just as much over time:
How much of that return did you actually keep?
Taxes are an easily overlooked source of investment drag. Capital gains distributions, realized gains, dividends, interest income, and the timing of portfolio trades can all affect the amount that ultimately remains in an investor’s pocket.
The magnitude can be surprising. Research highlighted by Dimensional Fund Advisors has shown that a portfolio’s tax cost—the portion of return lost to taxes—can sometimes exceed the investment expenses investors spend so much time scrutinizing. Investors may agonize over a few basis points of fund expenses while paying far less attention to potentially larger tax consequences.
And small differences compound.
Consider a hypothetical $1 million portfolio earning 7% annually. If additional tax drag reduced the amount left compounding by just half of one percentage point per year, after 20 years the difference would be roughly $350,000.
Taxes, of course, cannot simply be eliminated. Nor should minimizing taxes be the sole objective of an investment strategy. A decision that saves a dollar in taxes but costs two dollars in investment return is hardly a victory.
The opportunity lies in managing when and how those taxes occur.
That can mean harvesting losses during market declines to offset gains elsewhere. It can mean being thoughtful about which tax lots are sold when raising cash or rebalancing. It can involve limiting unnecessary short-term gains, managing portfolio turnover, considering the tax characteristics of investment income, and coordinating investments held across taxable and tax-advantaged accounts.
Done well, these decisions are not isolated year-end maneuvers. They are part of the ongoing management of a portfolio.
Tax-loss harvesting provides a good example. Market volatility can create opportunities to realize losses while keeping a portfolio invested in similar market exposures. Those losses can then potentially offset realized gains elsewhere in the portfolio or be carried forward for future use. The market decline itself may be unwelcome, but thoughtful portfolio management can sometimes turn part of it into a useful tax asset.
For example, suppose a period of market volatility creates an opportunity to harvest $30,000 in losses within a taxable portfolio while keeping the portfolio broadly invested. If those losses are later used to offset $30,000 of long-term capital gains that would otherwise be taxed at a 23.8% federal rate, that could represent roughly $7,140 in current federal taxes avoided or deferred. The exact benefit will depend on the investor’s circumstances, and in many cases tax-loss harvesting is more about deferring taxes than eliminating them altogether. But that deferral can still be valuable: money that does not leave the portfolio today can remain invested and continue compounding, while the harvested loss may provide additional flexibility elsewhere in the financial plan.
The important point is not that investors should constantly trade in pursuit of lower taxes. Quite the opposite. Tax decisions need to be weighed alongside expected returns, diversification, transaction costs, income needs, and the investor’s overall financial plan.
That is why we believe investment management should be evaluated on more than the return shown on a performance report.
Markets determine much of what you make. Portfolio management helps determine how much you keep.
At Hanover Advisors, tax-aware portfolio management is not a once-a-year exercise. It is part of how we think about investment decisions throughout the year, looking for opportunities to reduce unnecessary tax drag while keeping each client’s broader financial plan in view. If you have questions about how taxes may be affecting your portfolio, contact us today.