Tax-Aware Mindset: Seeking a Strategic Portfolio Balance

When we think about portfolio diversification and taxes, we tend to slot them into separate categories, each one entailing its own unique domain of requirements, goals, and tasks. Like apples and oranges, they seem to have little in common. Portfolio diversification is about mitigating risk while pursuing portfolio growth. Paying taxes, on the other hand, seems more like a necessary annual interruption—one that can even get in the way of your financial goals.

But interestingly, these seemingly disparate activities can be combined to create a potentially effective investment approach. In other words, by investing with a tax-aware mindset, you might enhance your diversification in a way that can potentially mitigate both your market risk and tax burden, ultimately helping you keep on track toward your financial goals.

If portfolio diversification means strategically balancing the debt instruments (fixed income securities) and stocks (equity securities) in your portfolio to target investment income, maximum growth, and lower risk, here are two tax-efficient strategies to consider:

1. Swap taxable debt assets for tax-free alternatives
2. Harvest equity losses to offset capital gains or dividend income

Let’s start with the first item: debt or fixed income securities.

Swapping Taxable Debt for Tax-Free Debt Securities

Like many investors, you may be holding a certain percentage of bonds and various fixed income instruments to balance and help to diversify your portfolio. The problem is that certain bond types are taxed (on the federal and state level) as ordinary income tax. And if you are a retiree, your tax bracket may be higher than during your early working years.

Here’s an idea. If you want to allocate a portion of your portfolio to income-bearing assets, have you considered swapping some of your taxable debt securities with municipal bonds (“munis”)? Munis are fixed income securities that cities, counties, or states issue in order to raise capital for public works (e.g., building roads, bridges, and various other local infrastructure).

Why munis? They’re generally tax-free at the federal level. Some are even tax-free at the state level. And if you happen to live in a high-tax state like California or New York, then swapping a portion of your taxable bonds for tax-free munis may be a smart way to receive interest-bearing returns minus the tax burden. (Be sure to verify the tax-free nature of any municipal bond with the issuer prior to purchasing.) As with all investments, there are risks and trade-offs with munis, so weigh the pros and cons before investing.

Interest income and capital gains on municipal securities may be subject to the Alternative Minimum Tax.

Tax-Loss Harvesting to Offset Capital Gains and Dividend Income

But what about the growth portion of your portfolio? How might you potentially minimize the tax burden for stocks and stock dividends?

Most investors are familiar with capital gains taxes, likely thanks to the chunk of change they ended up paying Uncle Sam for stocks sold at a profit. But many investors may not be as familiar with the concept of tax-loss harvesting. And that’s too bad, because tax-loss harvesting can be an effective way to offset capital gains.

Let’s go over a few basics, starting with capital gains. When you sell a stock at a higher price than you paid for it, you’ll likely have to pay taxes on the gain. Capital gains taxes can be as high as 20% for stocks you’ve held for more than a year, but for stocks you’ve held less than a year, the profit is considered ordinary income and booked as a short-term gain.

Now, staying diversified in an ever-changing market environment sometimes requires selling some stocks in order to hold cash or buy other assets. Selling stocks at a profit may subject you to capital gains taxes, but selling stocks at a capital loss may help offset capital gains by as much as $3,000 per year under current tax laws. That’s tax-loss harvesting. It takes advantage of an IRS rule that allows realized losses to offset realized gains in your taxable portfolio. If you harvest your losses strategically, you may be able to minimize, or in some cases eliminate, your capital gains taxes.

To better understand how tax-loss harvesting works, imagine a scenario in which you invest $100,000 in two securities, putting $60,000 in Security A and $40,000 in Security B.

At the end of one year, suppose Security A has declined by $7,000 and is now worth $53,000. But Security B has risen by $10,000 and is now worth $50,000.

Without tax-loss harvesting, if you sell the shares in Security B, you’ll have a realized gain of $10,000 from Security B and a potential capital gains tax bill of $1,500 at 15%.

On the other hand, with tax-loss harvesting, you might sell Security A to offset the gains from Security B. At the end of the year, instead of paying $1,500 in tax, you’d only have a potential tax bill of $450, for a potential tax savings of $1,050. That savings can be invested back in the portfolio or used to maximize IRA contributions, pay off debt, or spend elsewhere.

In some cases, you may even be able to sell a security at a loss while buying a similar one at a lower price without violating the wash sale rule. But stay on the safe side and consider consulting a financial professional before you attempt this. Looking for additional information on using tax-loss harvesting to pursue a more tax-efficient portfolio? Watch the video below.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances. Tax-loss harvesting is not appropriate for all investors. Investing in securities involves risk of loss that the client should be prepared to bear. 

Combining Municipal Bonds with a Tax-Loss Harvesting Strategy

Swapping taxable bonds and fixed income assets for tax-free municipal bonds and using tax-loss harvesting can potentially help you offset taxable equity gains or dividends.

By maintaining a tax-aware mindset, you may be able to widen your diversification capacity, potentially helping to mitigate not only market risk but also a weighty tax burden. And by combining these two strategies—muni investments with tax-loss harvesting—you may be able to pursue a compounding positive result in both your income and portfolio growth goals.

This strategy may seem relatively simple in concept, but it takes a rigorous degree of portfolio personalization. It requires both thorough investment research and an understanding of tax rules.