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The Tax Friction in Portfolio Rebalancing
Tax Efficiency and Portfolio Management
The Role of Labor Income in Portfolio Strategy
Our Further Interpretations
Balancing Tax Efficiency and Portfolio Growth
The Importance of Strategic Tax Management
The Final Bottom Lines
“The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital… the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy.” – John F. Kennedy
Capital gain recognition and the income taxes resulting, have a significant influence on investors’ (and our clients’) portfolio rebalancing decisions and optimal asset allocation over a lifetime. Coming off the historically high tax rates during the years of the Eisenhower administration turned President Kennedy into a tax cutter, and his quote indicated his depth of understanding of taxing capital.
The Tax Friction in Portfolio Rebalancing
A major friction faced by investors is the tax liability triggered by the sale of appreciated assets, which affects their ability to rebalance portfolios efficiently. A seminal study completed for The Review of Financial Studies in 2001, “Optimal Consumption and Investment with Capital Gains Taxes”, by Robert M. Dammon, Chester S. Spatt and Harold H. Zhang, models the trade-off between tax costs and diversification benefits, demonstrating that the size of the embedded capital gain and the investor’s age play significant roles in decision-making. Your reaction may be, “Wow 2001! Can’t you find something more up to date than that?” Well no, I could not. And Long-Term Capital Gain (LTCG) rates are what they are; less than ordinary income and short term gain rates, with just that relative difference over time. Both LTCG and ordinary income rates were higher in 2001. And the ability to step up basis upon death has not changed since then.
The study finds that as the size of an investor’s capital gains increases, their incentive to rebalance diminishes due to higher tax costs. Conversely, younger investors with lower capital gains are more likely to adjust their portfolios to achieve optimal diversification. However, as investors age, the tax benefits of holding onto highly appreciated assets increase because the U.S. tax code resets the capital gains tax basis to the asset’s market value at death, effectively eliminating the tax liability for heirs. This provision often makes it advantageous for elderly investors to retain or even increase their equity exposure, contrary to conventional advice suggesting that equity allocation should decrease with age.
Tax Efficiency and Portfolio Management
The models in the study considers a tax environment where capital gains taxes are triggered only at realization and forgiven at death. It assumes a constant tax rate for capital gains and simplifies complexities like short-term versus long-term tax treatments. The research emphasizes that efficient tax management, such as deferring the realization of gains or harvesting losses, significantly enhances the portfolio’s utility. It also highlights the inefficiencies of alternative strategies, such as always realizing gains or following a strict buy-and-hold policy.
Aside from the study, it is indeed interesting that popular recognition of gains in chiefly equity investments, entirely ignores the effect of capital gains taxes, particularly short term gains. It is simply all important that an investment increases, and many managers or investors tout their timing of those gains, the holding period be damned! Why is this a critical part of the return assumption? An investor in the state of New York, in a top bracket for a short-term capital gain, would pay a federal 37% rate, plus 3.8% surcharge, plus a 13.3% tax to the state. Are investors seriously day trading tech stocks, options, cryptocurrency and more, to achieve a gain, and then pay 54.1% to the government on those gains? This is just another example of time in the market beating time out of the market; the more time in the market, the more return is added, which in the above example is 17%. So what is it? Why does programming on CNBC, Fox Business, Bloomberg seemingly ignore taxes as they cite gains? Too boring, too complex, too much reality getting in the way of the fun? Perhaps a combination, but an occasional reality check, or caveat on trading might be refreshing, and truthful?
Back to the study, we note that key findings reveal that elderly investors benefit most from deferring capital gains taxes, particularly as their life expectancy shortens, making the reset provision at death more valuable. The study contrasts this with Canadian tax rules, where unrealized capital gains are taxed at death, eliminating the U.S. deferral advantage and resulting in different portfolio allocation strategies.
The Role of Labor Income in Portfolio Strategy
Additionally, the research discusses how labor income, which ceases during retirement, impacts portfolio decisions. Younger investors with labor income tend to hold more equity, while older investors focus on preserving gains and maximizing post-tax wealth. The study also examines the effects of varying capital gains tax rates and stock return volatility, finding that higher taxes and increased volatility reduce equity exposure, particularly for younger investors.
The paper concludes that understanding the interaction between taxes, age, and portfolio composition is essential for optimizing investment strategies. It highlights the importance of tailoring advice to individual circumstances, such as the size of capital gains and the investor’s stage in life, to achieve tax-efficient portfolio management and enhance overall financial well-being.
Our Further Interpretations
Capital gains taxes significantly influence how investors manage their portfolios, particularly when it comes to rebalancing. While rebalancing is essential for maintaining diversification and managing risk, the tax liabilities triggered by selling appreciated assets can complicate the decision. These considerations become even more critical as the size of an investor’s capital gains and their age increases.
Balancing Tax Efficiency and Portfolio Growth
For younger investors, rebalancing is often a straightforward decision. With smaller gains and more time to recover from the tax costs, they can adjust their portfolios to align with their long-term goals. Diversification benefits typically outweigh the tax liabilities in these cases, making rebalancing a practical and effective strategy. However, as investors age, their priorities shift. The larger the accumulated gains, the higher the tax cost of selling, which often deters rebalancing.
Here is where the U.S. tax code offers a unique advantage: the reset of the capital gains tax basis at death. This provision allows heirs to inherit assets without the burden of the deceased’s capital gains tax liability, as the tax basis is adjusted to the market value at the time of death. This rule transforms how older investors approach their portfolios. Instead of reducing equity exposure as they age—following conventional advice—they may find it more beneficial to hold or even increase their positions in appreciated assets. Retaining these investments not only defers the tax burden but also maximizes the benefit for their heirs.
The Importance of Strategic Tax Management
Effective tax management plays a critical role in optimizing portfolio performance. Deferring the sale of appreciated assets and harvesting losses are two strategies that can enhance long-term returns. For example, selling underperforming assets at a loss can offset gains, reducing the overall tax burden. This notes the “Yin and Yang” of tax management; when portfolios are up, a rebalance takes place to recognize gains, and adjust the high performing sectors down. When markets reverse, losses are recognized. Dependent on market volatility, that gain or loss adjustment could take place within a tax year. On the plus, it can be looked upon as a virtuous cycle; if markets are up, you lock in gains by rebalancing. If markets continue to rise, who complains about that? When markets fall, tax loss selling takes place. If that happens intra-year, gains can be offset. Regardless, the prior gain recognition rest basis, making tax loss selling an easier calculation. On the other hand, rigid strategies like always holding onto assets or frequently selling without a plan can result in missed opportunities, a disparate portfolio versus market targets, and unnecessary costs.
The tax landscape is not the only factor to consider. Life stages also affect portfolio decisions. Younger investors with ongoing labor income often have the flexibility to take on more risk, using their income to rebalance portfolios without triggering significant tax liabilities. As retirement approaches and labor income stops, the focus shifts to preserving wealth and managing taxes efficiently.
External factors like capital gains tax rates and market volatility also influence portfolio management. Higher tax rates make it more expensive to rebalance, particularly for younger investors who benefit most from diversification. Similarly, increased volatility can discourage equity exposure due to higher perceived risks, though it may also present opportunities for tax-efficient rebalancing.
Ultimately, portfolio management is about balancing diversification with tax efficiency, and there’s no one-size-fits-all approach. Tailoring strategies to your age, financial goals, and unique tax situation ensures you are making the most of your investments now while maximizing benefits for future generations. Thoughtful planning can turn your portfolio into a tool that not only builds wealth but also secures a strong legacy.
The Final Bottom Lines
Don’t let the tax tail wag the investment dog! As noted, popular business and investment media entirely ignore taxes, where we find some clients putting too much emphasis on taxes. While the timing of capital gain recognition should be considered, a multi-year process of keeping gains without a rebalance, kicks that gain can down the road, and often reduces portfolio gains in the process. One of our wealthiest and most pragmatic clients recognizes that she will always be in the top bracket for long-term capital gains, a combined nearly 31% federal and state rate. But she also recognizes that she will keep 69% of her recognized gains, and that she is not turning over the entire portfolio every year, just a part of it. The dollar amounts of tax paid is indeed breathtaking, in many years more than is spent on consumption, but again, she keeps the majority of gains, and her portfolio keeps growing.
If you were to take yourself back to September of 2007. Markets are roaring, coming off about five years of recovery and gains from the 2000 tech crash and September 11 market swoon. An advisor recommended rebalance would have resulted in higher gains taxes than today, but also would have taken profits off the table to the fixed income; another 18 months hence, to the market low of March of 2009, would you have regretted taking those profits at the market high?
There is lot to unpack with this, but these are all-important recognitions to have in our long-term portfolio balance and management process. We will not hesitate to raise this article again and again, as resistance mounts to gain recognition with the rise in markets.
Disclosure
Aurelius Family Office, LLC (AFO) is registered as an investment adviser with the SEC and Noticed Filed with the state(s) where it transacts business, unless excluded or exempted from filing requirements. This communication is for information purposes only, and it is not intended to provide specific legal, tax, or other professional advice. Investments involve risk and unless otherwise stated, are not guaranteed. Although information has been obtained from sources deemed to be reliable, we make no guarantee as to the accuracy or completeness of this data. AFO shall not be liable for any errors or omissions, or for any actions taken in reliance thereon. Be sure to first consult with a qualified professional adviser before implementing any strategy discussed herein. Past performance is not indicative of future results.
