After ATRA, Tax Management Gains Importance

The US tax reform just enacted has made effective tax management of portfolios far more valuable for some investors. The old rules of thumb never really worked, but their shortcomings will now cost investors more.

 The American Tax Relief Act (ATRA) raised the top marginal income tax rate to 43.4%—the highest level since 1986. It also pushed the top capital gains rate from 15% to 23.8%. In a taxable portfolio, every trade has a possible tax impact, and the higher these rates, the greater the impact will be.

Once a trade has cleared the basic tax hurdle we discussed in a recent blog posting , the investor (or portfolio manager) must decide which lot to sell first. Most portfolio holdings consist of several tax lots purchased at different times and prices. In choosing which lot to sell first, a tax-aware portfolio manager aims to minimize an investor’s current tax payments by picking the one that will generate the lowest tax expense.

Most managers resort to a few accounting rules of thumb: HIFO (highest in, first out); LIFO (last in, first out); or FIFO (first in, first out). These techniques are relatively easy to implement but crude. HIFO will sometimes generate the lowest capital gains tax, but not always. If the highest-cost tax lot was bought less than a year ago, it will generate a short-term gain subject to a much higher ordinary income tax rate; in fact, it might incur the largest capital gains tax. LIFO and FIFO have similar limitations.

The only surefire way to sell the lots that will generate the lowest taxes is to calculate the tax cost of selling each and every tax lot and then pick the most favorable. Trading on the basis of calculations rather than rules of thumb may provide substantial benefits to all investors with taxable portfolios, but it is likely to be especially helpful to those subject to the new, higher rates. Maximizing after-tax returns is a complex endeavor that in most cases will best be left to professional managers who do a good job of incorporating taxes into their decision making.

Bernstein does not give tax or legal advice. Taxpayers should consult professionals in those areas before making any decisions.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Paul Robertson

Senior Portfolio Manager
Paul Robertson is a Senior Portfolio Manager and a member of Bernstein’s Private Client Investment Policy Group. He joined the firm in 1998 as a research associate and became a research analyst in 2000. In 2004 Robertson was appointed Senior Portfolio Manager and joined the Private Client Investment Policy Group. Between 2007 and 2009 he was also a member of the Alternative Investments team. Previously, he worked as a consultant for McKinsey & Co., Inc.; as a portfolio manager and quantitative analyst for Commonwealth Funds Management, an Australian funds manager; and as an economist for the Australian government. Robertson earned a bachelor’s degree in economics from the University of Melbourne, a law degree from the Australian National University and an MBA from Cornell University.

Daniel B. Eagan

Managing Director—Consultant Relations
Daniel B. Eagan assumed his current role as Managing Director of Consultant Relations in 2013. He joined Bernstein in 2001 as a senior portfolio manager and has held a number of senior leadership positions, including leader of the Private Client practice in the Pacific Northwest and head of the Wealth Management Group. Prior to joining Bernstein, Eagan was a senior portfolio manager and managing director at BlackRock for seven years. Prior to that, he worked in investment consulting, most recently with Mercer Investment Consulting. Eagan holds a BS in finance from the University of Illinois and an MBA with distinction from DePaul University. Location: San Francisco

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