This time of year we take a hard look at portfolios to help mitigate the tax drag on investment performance. “Taxes are a big cost—perhaps the biggest for high-earners—but are also among the least thought about,” according to a Morningstar analyst.

Not everything that can be counted counts, Albert Einstein famously said.  This is so true when applied to investment performance.  What counts is what you keep after taxes!  The prudent investor of today carefully plans to reduce the tax drag on investment performance by applying a few basic techniques.

Bracket management.  The basic idea is simple—manage income across annual tax brackets to smooth out income, avoiding tax spikes from inopportune realization of gains.  Income smoothing strategies involve (1) reducing taxable income in high-income years by maximizing deductions and shifting income to lower-income years; and (2) increasing income in low-income years by deferring deductions and increasing taxable income to fill up the lower tax brackets.  The power of tax-deferral also is impressively utilized to manage distributions from retirement plans.  An AICPA publication provides more detail.

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Asset location.  Tax-efficient asset location is putting assets in tax-deferred accounts such that the government’s tax subsidy is maximized. In practice, this means stuffing higher-yielding investments generating ordinary income in tax-deferred accounts, and keeping stocks in taxable accounts.  A Morningstar analyst explains.  (free registration)

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Municipal bond ladders and similar tax-advantaged investments will be used by taxpayers in the highest brackets, even if it means accepting a lower return.  With municipal bond ladders, investors take 100 percent control over the credit risk and the term risk of their portfolios.  Another key advantage is the ability to maximize the after-tax return on municipal bonds by tailoring the portfolio to the individual’s state and tax bracket.  This strategy fits nicely into the “safety first” approach discussed in last week’s blog

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J. Mark Nickell &  Co.

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