Tax-Aware Investing for the 21st Century


Benjamin Franklin had it right when he said, “In this world nothing is certain but death and taxes.” For investors, it pays to be mindful that it is not only fees that reduce investment returns; taxes have an impact as well.

Money managers typically focus on pre-tax investment returns, leaving it to investors and their financial advisors to deal with the tax consequences. As a result, interest in tax-managed investments has grown considerably; the number of tax-managed mutual funds increased from 18 in 1995 to more than 200 a decade later (source: Lipper Investor Services).

While many strategies and techniques are available for individuals to minimize the impact of taxes on an investment portfolio, let’s explore some of the more popular ones.

Personal Trust Services

In this approach, the potential impact of taxes on a portfolio is not part of the investment decision-making process. The approach is most suitable for tax-deferred accounts like an IRA or a 401(k) plan.

Tax-Aware Investing

This approach, which seeks to generate the most efficient after-tax gains, can be passive or active.

Passive tax management uses tax-exempt or tax- advantaged investment instruments such as municipal bonds, certain structured products or securities that have low current income/yield. Money managers may also rely on a buy-and-hold strategy, which can potentially minimize transaction-triggered tax events.

Active tax management is the practice of selective tax- loss harvesting on top of the tax-managed instruments and strategies described above.

Client-Centric Financial Planning

Here, the financial advisor assists his or her client in deciding asset “location” as well as asset allocation. As- set location involves deciding what type of assets belong in taxable or tax-advantaged (e.g., IRA) accounts. As an example, a high-turnover equity strategy may be invested in an IRA while a municipal bond strategy is pursued in a taxable account.

Municipal Bonds and Municipal Bond Funds

Municipal bonds benefit from federal tax exemption. They also are exempt from state and local income tax for residents of the issuing state. However, both municipal bonds and municipal bond funds may be subject to the federal Alternative Minimum tax (“AMT”). You may be subject to the AMT, you should look for municipal bonds whose income is not taxable for AMT purposes, or for a municipal bond fund that has a portfolio where a low percentage of bonds produce AMT income.

For investors holding municipal bonds issued outside of their state of residence, those bonds may produce interest that is taxable at the state and local levels. State-specific bond funds generally limit their investments to the bonds issued within a single state, which address investor concerns over subjecting such income to state and local taxation.

Tax-Managed Equity Funds

Tax-managed mutual funds consider taxes on capital gains and dividends as part of their investment strategy. They will pursue one or more strategies in an attempt to mitigate the effect of taxes, including deferring the realization of capital gains or engaging in loss-harvesting to offset capital gains. A concentrated low-turnover strategy is also regarded as potentially having tax benefits.

Exchange-Traded Funds

Since their introduction in the 1990s, exchange-traded Funds (ETFS) have proven to be relatively tax-efficient due to the way ETFS are structured. For most investors, ETFS are bought and sold on the secondary market. Because ETFS can often raise funds for redemptions in a manner that is not taxable to investors, they tend to incur fewer taxable trans- actions in the normal course of operations than a similar non-exchange-traded fund might. Investors will, of course, be subject to taxes on the realized gain arising from the sale of the ETF.

Fund selection, portfolio construction and tactical asset allocation are key components of a total approach to tax-aware investing.

Fund Selection

Research should explore the effectiveness of funds and ETFS both as tax-efficient investment vehicles, as well as their long-term performance track records and risk characteristics.

Portfolio Construction

Municipal bond funds can be a good foundation for the fixed-income portion of any tax-aware investment portfolio. Presently, there are few ETFS in this space, so actively managed mutual funds may be the best vehicle for a diversified, tax-efficient fixed-income portion of the portfolio.

For equities, a core-satellite portfolio structure can help address the tax sensitivities. For example, ETFS as the U.S. large-cap allocation can constitute the tax-efficient core, supplemented by actively managed funds in the small/mid-cap and international equity asset classes.

For alternative investments, market-neutral or long-short strategies, as well as a core investment in the commodity markets, may complement other components of a tax-aware portfolio.


Investors may not need to consider the impact of taxes on every investment decision they make. Indeed, investors should make sure that the tax “tail” does not wag the investment “dog.” nevertheless, an informed philosophy regarding tax-aware investing can give investors a starting point for deciding which instruments and strategies they should consider with the help of their financial advisor when investing with a view toward tax efficiency.

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This article has been written and provided by UBS Financial Services Inc. for use by its financial advisors.

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Neither UBS Financial Services Inc. nor its financial advisors offer tax or legal advice. You must consult your tax and legal advisors regarding your particular situation.

The information contained in this article is based on sources believed reliable, but its accuracy cannot be guaranteed. This article is for informational and educational purposes only and should not be relied upon as the basis for a purchase decision. This article has been written and provided by UBS financial services Inc. for use by its financial advisors.