Building a Tax-Efficient Portfolio For Yourself

Building a tax-efficient portfolio so you can keep more of your investment income and capital gains is a concern of investors the world over. In India, for example, the government has created a “tax-saving mutual fund” with tax benefits in mind. In the United States there are several fund-focused ways to save on taxes, which are described below. Consider working with a financial advisor to build a comprehensive tax planning strategy.

India’s Tax-Saving Mutual Funds

Those able to invest in India-based securities may be able to put money into one of the country’s tax-saving mutual funds, also referred to as equity-linked saving schemes (ELSS). These are open-ended mutual fund that invest at least 80% of their assets in equities or equity-linked securities. Underlying investments can include small-cap, mid-cap and large-cap companies, depending on the objective of the fund.

A tax-saving mutual fund or ELSS, which entails a three-year lockup period, offers various tax benefits. These include tax exemptions for invested amounts and favorable tax treatment of capital gains.

Unified Management Accounts (UMAs)

In the United States, investors can pursue tax efficiency through both specific types of securities as well as specific types of financial services. One of the most widely used type of securities is unified managed accounts (UMA), which money managers often construct to help achieve tax efficiency in taxable accounts and to simplify yearend tax filing.

If you want to open one of these accounts, you’d first work with an advisor, wealth manager or portfolio manager to decide which assets you want to hold inside the UMA. Once those assets are selected, they’re aggregated and collected into the UMA. The next step is developing an investment strategy for managing UMA assets. However, this strategy is different for every investor who uses a UMA and is based on their objectives, diversification needs, the timeline for investing, risk tolerance, risk capacity – and need to minimize taxes.

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UMAs are rebalanced often to keep the account’s asset allocation on track with your needs and preferences. However, rebalancing is approached in a way that keeps your entire comprehensive financial plan, including tax efficiency, in focus.

Turnkey Asset Management Programs

A turnkey asset management program (TAMP) offers another way for investors to achieve tax savings. With a TAMP one or more advisors oversee all of the associated tasks that go along with managing client assets on an individual basis. A TAMP allows advisors to outsource certain tasks so they can focus more of their time and energy on others. For example, a TAMP may outsource reporting and accounting to focus on such priorities as tax savings.

Here are three popular TAMPs:

Mutual Fund Wrap Accounts

A mutual fund wrap account offers multiple mutual funds. Their fees wrap around all of a client’s mutual fund trading activity. As a result, an advisor can design a portfolio of mutual funds tailored to a client’s investment goals. This type of TAMP structure offers a simplified way to manage client assets while reducing fees.

Exchange-Traded Fund Wrap Accounts

This type of wrap account resembles a mutual fund. However, investment choices are limited to exchange-traded funds. Cost-efficient ETFs give this type of wrap account slightly lower fees compared to a traditional mutual fund wrap account.

Separately Managed Accounts (SMAs)

A separately managed account is designed for investors with higher levels of investable assets and it operates similarly to a mutual fund with one key difference. Rather than pooling money together from other investors, all of the investments in an SMA are owned by a single investor.

Tax Overlay Services

A tax overlay service (TOS) enables money managers to monitor a client’s separate accounts to ensure that changes in one account don’t work against changes in another account. A TOS, which is often used by the very wealthy, works off software that coordinates the tactics of each account so each one works in coordinated and efficient harmony to advance a client’s overall strategy.

This service works to minimize a client’s tax exposure, especially on short-term gains that cannot be deferred. Managers can also use this service to match long-term capital gains with short-term capital losses and tax-loss harvesting.

Building a Tax-Efficient Portfolio for Yourself

Tax-saving mutual funds are just one option for minimizing taxes on investments. If you don’t have the opportunity to invest in an ELSS, you might consider some of these options instead.

• ETFs: Exchange-traded funds are mutual funds that trade on an exchange like a stock. An ETF can be a tax-efficient addition to a portfolio since they tend to have lower turnover than traditional funds. That means fewer taxable events for investors.

• Index Funds: An index fund attempts to mimic the performance of an underlying benchmark, such as the S&P 500. Like ETFs, index funds tend to have a lower turnover of underlying assets, so there’s less potential to trigger short-term capital gains.

• Tax-Managed Funds: A tax-managed fund can offer tax-efficient growth by minimizing taxable dividend income. You can get the benefits of diversification and exposure to equities, without increasing tax liability.

• Municipal Bonds: Municipal bonds are issued by state, city and local governments. While they may not offer the same degree of performance as a stock-focused fund, any income generated by these bonds is usually tax-exempt at the federal level.

Bottom Line

A tax-saving mutual fund offers a unique path to minimizing taxation for investors. As an added plus, they typically have a lower barrier to entry, making them accessible to those who are just getting started in the market. Whether it makes sense to invest in one of these funds can depend on your tax situation and risk tolerance.

Tax Tips for Investors

• Consider talking to a financial advisor about how to manage and minimize taxes. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Check out SmartAsset’s income tax calculator to get a quick estimate of what you will owe the government for the year. This can help you plan your finances for the following year.

• Asset location is just as important as asset allocation for managing taxes as an investor. Contributing to a 401(k) or IRA are two simple ways to enjoy some tax benefits while building long-term wealth. Your contributions may be tax-deductible and in the case of a Roth IRA, qualified withdrawals are tax-free. If you don’t have an IRA yet, it’s easy to open one through an online brokerage.

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