From Tax Cuts to Tax Management

For the past 10 years, Americans have enjoyed historically low tax rates. The Bush-era tax cuts passed in 2001 and 2003 created a six-tier tax bracket based upon personal income levels and a relatively low capital gains/qualified dividends tax rate. In 2008, investment and accounting professionals began discussing what to do when the 2001 and 2003 Tax Acts expire. The proverbial can was kicked down the road with the election of President Obama in 2008 and his stimulus provisions that extended the Bush tax cuts (2009-2012).


In the early hours of 2013, these questions began to be answered with the agreement reached to avoid the “Fiscal Cliff.” In this context, we stay tax conscious throughout our investment process and implement multiple strategies in an effort to be tax efficient. This begins through the choice of investment vehicles.

Balentine’s passive bias creates efficiency by reducing turnover, and our use of exchange-traded funds (ETFs) rather than individual securities further enhances ease and efficiency. As part of this process, year-end tax management entails pulling individual account level unrealized loss data to determine if any holdings have increased or decreased enough to warrant tax loss harvesting. Balentine also contacts Mutual Fund managers during the fourth quarter to determine whether they expect any capital gains/losses to be distributed. Taxes are not the primary driver in the investment process, but we do consider these aspects in our decision making process.

There are numerous investment vehicles available to shelter income and profits from taxes. The following paragraphs will review the merits and appropriateness of two specific investment strategies employed by investors to manage tax liabilities and how these strategies fit into the Balentine investment model.

The first area for consideration is the use of taxable and municipal fixed income products in a portfolio. Traditionally, taxable bonds are placed in client accounts that have a non-taxable status (institutions such as endowments and foundations and individual retirement accounts), and municipal bonds are placed in taxable accounts.

Some argue that all things being equal, if after-tax returns of taxable bonds equal the returns of non-taxable municipal bonds, investors will be indifferent between the two. In that case, two separate implementation vehicles, one for taxable and one for tax-exempt clients, would be redundant. In such a case, managers should use one vehicle for simplicity. We continue to maintain two separate implementation vehicles given the following considerations:

  • The potential increase in tax rates on income makes municipal bonds more attractive.
  • Default rates for municipals are historically lower than corporate bonds.
  • Municipal bonds have historically shown similar return streams with lower volatility relative to corporate bonds.
  • Municipal bonds are currently offering more attractive spreads over comparable treasury bonds versus corporate bond spreads.

We then considered including a tax managed index product in the portfolio. Index products that offer the benefit of tax loss harvesting can look enticing, but the following two considerations must be taken into account:

  • Investors must take a large position to generate a tax benefit great enough to offset any gains from other assets in the portfolio.
  • A minimum static holding period of greater than 1, but often closer to 5 years is necessary to receive a substantial tax savings from the strategy.

Not all investments will benefit from a tax loss-harvesting program, but the opportunity to enhance returns via lower tax liabilities is certainly one worth pursuing and therefore would be reviewed on a case-by-case basis.

Advisors should always consider taxes when advising taxable clients and should evaluate each strategy at the client level to determine if the inherent tax advantages can be recognized. Considerations include the following: effective income tax rate, capital gains tax rate, dividend tax rate, alternative minimum tax, time horizon, liquidity and tracking error. This process should be done on a continuous basis throughout the year and not simply at year-end. Tax management plays an important role at Balentine, but it does not overshadow the investment process or tactical decision-making.

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