Want to deliver more tax-efficient income strategies?

A comprehensive approach to model construction that includes tax-loss harvesting can help advisors thread the needle between tax efficiency and effectiveness. Here’s how.

For some time, investors faced a challenging search in order to find an elusive yet increasingly important goal – income. Whether to drive total return or meet liabilities, income plays an essential role in most financial plans, but is often addressed by complex and higher cost financial instruments such as annuities, or augmented by capital drawdowns as conventional tax efficient income generators (dividends, Muni bonds etc.) were, until very recently at least, too low yielding.

In order to produce needed levels of income investors often are forced to move to higher volatility, less tax advantaged instruments such as corporate bonds, preferred securities, covered calls etc., which require both return and a watchful eye on risk. Multi-asset income models and funds have often been attractive vehicles for accessing pockets of yield as they emerged. However for investors needing income from their taxable portfolios, the tax implications of these inherently opportunistic approaches have been (and continue to be) problematic – if not downright prohibitive.

The Tax Problem

In light of the recent interest rate regime change, income-generating assets classes are delivering higher yields, but dislocations across income producing asset classes are creating opportunities for investors to benefit from price returns as well. An active approach to delivering return and managing risk can help drive better outcomes, but there is a tradeoff between investment objectives and tax efficiency as the very actions that can drive outcomes (sector rotation, rebalancing, etc.) often create adverse tax consequences.

Overall, the nature of the income streams these portfolios generate and the types of vehicles in which they are owned can make them tax inefficient, sometimes highly. The challenge for investors and their advisors is to find a way to meet their income needs without creating an excessive tax burden.

Before: Balancing Opportunity with Tax Impact

Now there’s a solution – in periods of heighted volatility, embedding systematic tax-loss harvesting into a comprehensive strategy that integrates harvesting and risk management with income generation and rebalancing can produce favorable, tax efficient outcomes. In short, deploy all the tools in today’s toolkit. Let’s walk through a couple of examples.

Example 1: Shift from a dividend growth equity strategy to a core dividend strategy.

Up until recently, the dividend yield on value stocks was certainly appealing relative to the low rates from bonds (The Russell 1000 Value had a yield of 1.96% at the end of January, especially given the inherent opportunity for gains, and had also performed well by gaining more than 160% over the last decade¹. In recent months however, not only has the yield fallen slightly, but the asset class has faced declines. There may now be a desire to lower exposure in order to access higher yielding opportunities elsewhere. And importantly, there may also be an opportunity to harvest losses in select tax lots.

Let’s assume an income model has an exposure to dividend growing stocks through a dedicated allocation. By incorporating tax-loss harvesting into the model, it would be possible to harvest losses in this allocation by replacing it with a core dividend strategy to lock in and harvest those losses without unduly impacting the model’s income generating capacity. The tax-loss can be used to either offset gains in other areas of the portfolio or be applied as an offset in a future state. In this example the dividend growth strategy may have even had a higher yield, but this advantage could have been more than offset by the ability to systematically harvest losses while adding a strategy with a similar income/opportunity profile.

In short, capital losses can be realized to offset the impact of taxes on the overall portfolio and income distributions – without compromising (and even potentially enhancing) the income generating potential of the strategy itself.

Example 2: Shift between an actively managed bond fund and a Muni bond ETF.

Losses can also be harvested on the fixed income side in a similar manner. As we saw in 2022, volatility isn’t always limited to the equity side of the equation. And while we’ll hopefully not see fixed income declines as severe as we saw in 2022 (the Agg down 16.1% through October!²) it may well pay to be prepared to benefit from volatility when (not if) we see it again.

If declines were experienced in, say an actively managed Muni fund within the income model then those losses could be harvested by selling the fund and replacing it with a passive Muni index ETF. The income and credit profiles could be left largely unchanged while losses harvested, and after-tax returns enhanced. Passive portfolios are often different enough from their active brethren that capital losses can be claimed for tax purposes without wash sale rules being invoked.

A Comprehensive Approach That Optimizes the Benefits and Opportunities

Tax-loss harvesting, if it’s done at all, is often done manually at year-end, and is typically aimed at equity portfolios. A comprehensive and systematic approach that automatically identifies these opportunities and acts on them as they occur throughout the year can be much more effective, even for fixed income or income-generating securities. Furthermore, a strategic approach to tax-loss harvesting in ways that increase tax efficiency also enables advisors to make more effective tactical decisions about how to generate additional alpha or higher income in their clients’ portfolios.

The market volatility seen in 2022 created significant opportunities for tax-loss harvesting. Even if 2023 proves to be less volatile, a systematic approach to tax-loss harvesting as part of a comprehensive approach to model portfolio construction can deliver the promise of multi-asset income strategies and help investors realize the income they need – in the most tax efficient way possible. 55ip provides advisors with a simple yet sophisticated way to achieve that objective for clients, while also ensuring that all additional considerations, like risk exposure and costs, are carefully managed.

Footnotes

¹10 years through Feb 1, 2023, Source Blackrock

²Source Bloomberg Barclays