Skip to main content
Investing

The Real Way To Amplify Your Investment Returns

By November 8, 2021November 30th, 2021No Comments

The financial media loves to lionize investment professionals who outperform the stock market. Never mind that almost no fund manager has sustained their edge for any length of time; those who capture “alpha”—beating the market, even if just by a hair—are accorded rock star status.

At AdvicePeriod, we don’t chase hot investment managers. We know that historically, low-cost indexes have been highly likely to outperform even the best of them, especially when taxes are factored in.1

We believe that some of the most effective levers for building wealth are those that are mostly off the media’s radar: Minimizing fees and taxes.

Keeping a bit more of your money each year isn’t a particularly glamorous topic. But plowing that savings back into your investments over many years can have a dramatic compounding effect. Consider how one of these wealth-building levers, tax management, works.

The best-known tax-management strategy for investors is known as tax-loss harvesting. Practiced within taxable accounts, tax-loss harvesting involves selling stocks or funds that have declined in value and using those losses to neutralize tax liabilities on realized gains.

Net losses up to $3,000 must be used in the same tax year they occur, but the IRS allows losses above that threshold to be carried forward indefinitely. No investment portfolio goes up in a straight line, and neither does any stock or fund within a portfolio. Tax-loss harvesting lets you turn those inevitable declines into tax erasers. And by reinvesting the proceeds after tax-loss sales, you maintain market exposure — a key element of successful investing.

In certain market environments, tax-loss harvesting can add more than 1% to a portfolio’s net performance annually, according to Vanguard research.

But effective tax management really starts before any losses or gains are booked, with investment selection. In general, ETFs may be more tax-efficient than mutual funds. An ETF’s underlying stocks are the same as those within the index it tracks. That means that the ETF won’t need to buy and sell stocks unless the index’s components change. As a result, ETFs accrue little to no capital-gains tax liability.

And unlike mutual funds, they are not required to disperse their capital gains to the shareholders at the end of each year—an event which creates an automatic tax bill. ETFs aren’t the only structure that investors can use to manage taxes effectively. In some situations, direct indexing can be a better tool. Direct indexing is similar to investing with ETFs, with some key differences.

Another lever for tax savings is known as asset location. Investments that are less tax efficient are best housed within tax-deferred accounts such as IRAs, while more tax-efficient investments can sit within taxable accounts. The order in which your investment accounts are drawn down during retirement matters as well. One popular drawdown strategy involves tapping taxable brokerage accounts first, and leaving investments in tax-deferred accounts to grow as long as possible. A recent study by Vanguard found that proper asset location can add three-quarters of a percentage point of value annually to an investment portfolio.

Every investor’s situation is different, so their tax-management strategy should be as well. But the bottom line is this: The secret to ending up with more money in your pocket isn’t guessing what the market will do, or which manager will get lucky and beat the market this year. It’s using the levers that are under your control. And tax management is one of the biggest levers you have.

Sources:
1 https://www.investopedia.com/articles/03/121003.asp

Disclosure