What is active tax managed investing?

Tax drag refers to the negative impact of taxes on an investors’ portfolio, slowing down its potential growth and reducing overall returns. It arises from the tax liability associated with various investment activities such as selling an investment for a profit, receiving dividends, earning interest. Some investment vehicles such as mutual funds or exchange-traded funds (ETFs) may distribute capital gains or income to investors, which are taxable and can result in a significant tax burden for investors. Managing tax drag is important to maximize after-tax returns and preserve long-term wealth.

Tax drag slows down a portfolio’s potential growth and represents a drag on returns, similar to how a rock tied to a runner would hinder their performance.

Advisors can help clients by implementing tax-managed investment strategies that aim to minimize taxable distributions and maximize after-tax returns.

Tax-loss harvesting involves intentionally selling an investment at a loss to offset capital gains taxes on profitable investments, resulting in a reduced tax bill and potentially more money left for investment. If the total capital losses exceed the capital gains in a given year, the investor can carry forward the unused portion of the losses to future tax years (capital loss carryforward). There are specific rules and limitations around capital loss carry forward, such as annual deduction limits and the expiration of unused losses after a certain number of years. Investors should consult with a tax professional.

Capital loss carry forward in mutual funds and ETFs allows investors to offset capital losses incurred in one year against capital gains realized in future years. If a mutual fund or ETF has net capital losses, it cannot distribute those losses to investors but can carry them forward. The fund can use the unused capital losses to offset taxable capital gains in future years, reducing the tax liability. Investors should consult tax professionals or regulations for specific rules and limitations on capital loss carry forward.

Active tax-loss harvesting involves continuously identifying opportunities to realize losses in a portfolio, minimizing short-term and long-term capital gain distributions, managing wash sales and focusing on qualified dividend distributions, which can lower tax liabilities and potentially allow for portfolio growth.

Although higher-income investors may experience more significant benefits, lower-income investors can likely achieve meaningful reductions in their tax bills by effectively harvesting losses.

While many investors wait until the end of the year to consider tax-loss harvesting, it may limit opportunities. Harvesting losses throughout the year, taking advantage of market corrections and volatility, can yield better results and maximize the benefits of the strategy.

A wash sale occurs when a security is sold at a loss and then repurchased within 30 days. The Internal Revenue Service (IRS) does not allow losses on a security sold in a wash sale. Investor should avoid wash sales to preserve losses than can be used to offset future gains.

Psychological factors such as aversion to realizing losses and the disposition effect, where investors tend to sell winners and hold onto losers, can hinder the implementation of tax-loss harvesting strategies.

Using IRS Form 1099-DIV, advisors can walk a client through the form and discuss the impact of dividend distributions on their income.

The Form 1099-DIV helps investors connect the dots between their investment returns and the impact of distributions on their total wealth return, allowing them to understand the potential tax implications.

Different sources of investment return are subject to varying tax rates, and being aware of these rates helps in making informed decision regarding tax planning and investment strategies to help optimize after-tax-returns for investors.

Form 1040 provides a comprehensive financial picture, including information on interest, dividends and capital gains, which can help identify tax implications and areas for improvement.

It's important to examine tax-exempt interest income, taxable interest, qualified and ordinary dividends, and capital gains to understand the tax impact on the client's investment income.

Requesting the Form 1040 helps advisors better understand the client's financial situation and provides an opportunity to offer advice to lower their tax bill and improve after-tax income.

Taxes can be triggered through dividend distributions, embedded gains that are distributed each year, and capital gains upon the sale of shares of the fund.

Tax-managed mutual funds aim to provide returns similar to non-tax managed funds while minimizing taxable transactions within the fund. By eliminating unexpected distributions, investors have more control over the tax year in which capital gains are reported.

Tax-managed refers to an investment approach that focuses on actively managing investments with the goal of minimizing tax impact and maximizing after-tax returns. It involves strategies such as tax-loss harvesting throughout the year and considering the tax implications of investment decisions. On the other hand, tax advantage generally refers to investments or accounts that provide specific tax benefits, such as tax-free municipal bonds or tax-advantaged retirement accounts such as Individual Retirement Accounts (IRAs) and employer-sponsored plans like 401(k) or 403(b)s. The difference is that tax-managed focuses on actively managing investments to minimize taxes, while tax advantage refers to investments or accounts that inherently provide tax benefits.

Tax-managed mutual funds aim to pay zero capital gain distributions, reducing the tax liability for investors. They also strive to minimize dividend income and focus on generating income in the form of qualified dividends, which are subject to more favorable tax rates.

Contact your financial advisor and/or tax professional for advice on how to best invest in tax-managed funds, based on your personal investment objectives and goals.

The pros: Tax-managed investing removes complexity from investing; saves advisors and investors time, effort & money; goes beyond tax loss harvesting with sophisticated investment management strategies; and aims for minimal taxable distributions.

The cons: Tax-managed investing cannot guarantee tax-free returns or better performance compared with traditional funds, and may have higher expenses and/or advisor fees.

Taxes can be a significant headwind for taxable investors, and actively managing the impact of taxes on investment portfolios can provide potential benefits for both investors and advisors. Advisors have the opportunity to assist clients in maximizing their after-tax wealth and potentially stand out in the industry by incorporating tax-smart strategies, including tax-loss harvesting, into their services.

The sale of real estate, the sale of a business, deferred compensation, inheritance, insurance proceeds, trusts, and current taxable assets.

Russell Investments’ tax-managed funds are unique because we’ve had 35+ years of experience in tax management to highly refine our approach. This approach includes active money management, centralized trading & implementation, tax loss harvesting, wash sale minimization, tax-smart turnover, holding period management, and fund yield management.

Russell Investments employs various principles of tax-managed investing, including year-round tax loss harvesting, reducing turnover, deferring realized gains, and strategically managing tax lots. We also use an internal overlay management team to coordinate trading activity across underlying money managers, enhancing tax efficiency.

Russell Investments has a disciplined tax-managed investment approach with 35+ years' experience. We have been continuously evolving our tax-managed investment expertise. Our active tax-managed investment approach goes beyond tax-loss harvesting, seeking to further increase tax efficiency to help generate the best possible returns.