Portfolio Construction Insights

If Taxes Increase, Are Your Clients' Portfolios Ready?

September 16 2021

A tax-efficient investment approach may help investors withstand rate increases.

Key Insights

  • As the Biden administration considers proposals to increase personal tax rates, investors have shown renewed interest in building tax-efficient models with the goal of maximizing after-tax returns.
  • Due to the preferential tax treatment, municipal bonds are one of the most impactful tools in a tax-efficient portfolio.
  • Tax-efficient gains within equities can be harder to find, but investors should consider the following:

– Tax-advantage investment vehicles, such as exchange traded funds (ETFs) and separately managed accounts (SMAs)

– Dedicated tax-efficient strategies

– Active mutual funds with tax-efficient alpha

  • Tax-efficient investors should focus on after-tax returns and tax cost ratios to evaluate strategies for tax efficiency.

Tax-efficient investing can maximize after-tax returns

The Biden administration is considering proposals to increase personal tax rates at a time when many investors find themselves with appreciated financial assets. As a result, there is a renewed focus on tax-efficient investing.

In this environment, the T. Rowe Price Portfolio Construction team offers important considerations for building a tax-efficient model, as well as various evaluation tools to construct these models. Tax issues can be complex and challenging, so we encourage investors to consult qualified tax experts for more specific guidance.

Fixed Income: Municipal bonds may offer return potential and diversification

One of the great benefits of the current U.S. tax code is its treatment of municipal bonds. Income received from municipal bonds is generally exempt from taxes at the federal level (and even at the state and local level too, if you live in the issuing state). With this preferential tax treatment, moving taxable bond allocations into municipal bonds can be a powerful tool when building tax-efficient portfolios.

The Portfolio Construction Solutions team believes it’s instructive to compare returns for municipal bond strategies versus taxable bond strategies on a post-tax basis. In Figure 1, we used Morningstar data to measure pretax and after-tax returns for select taxable and municipal intermediate bond and high yield categories.

Bonds: 15-Year Pretax and After-Tax Returns

(Fig. 1) Municipal bonds offered strong post-tax return potential.

Municipal bonds offered strong post-tax return potential.

As of June 30, 2021
Source: Morningstar Direct.
Calculation Benchmark: Morningstar Category Averages.
Category average performance is for illustrative purposes only and is not representative of any specific investment product. To learn more about the after-tax methodology used, see Additional Disclosures.
Past performance cannot guarantee future results.

As shown, pretax returns favored taxable bonds across most categories. However, municipal bonds came out on top for after-tax returns.

Examining tax cost ratios can also be helpful. Morningstar’s tax cost ratio measures how much an investment’s annualized return is reduced by the taxes investors pay on distributions. Figure 2 highlights the tax inefficiency of some taxable bond categories such as high yield. In addition, municipal bonds offered lower correlation to equities than taxable bond categories, and thus, could help enhance diversification benefits. (Correlation is a statistic that measures the degree to which securities move in relation to one another. Low correlation between securities typically indicates better diversification.)

Fixed Income Tax Cost Ratios (15-year) and Correlations

(Fig. 2) Municipal bonds offered more diversification and tax efficiency

Municipal bonds offered more diversification and tax efficiency

As of June 30, 2021
Source: Morningstar Direct. Standard & Poor’s.
Calculation Benchmark: Morningstar Category Averages.
Category average performance is for illustrative purposes only and is not representative of any specific investment.
To learn more about the after-tax methodology used, see Additional Disclosures.
Past performance cannot guarantee future results.

Equity: Seeking tax efficiency through vehicles and strategies

Equity tax efficiency can be more difficult and nuanced than fixed income. Equities have higher return potential than fixed income so taxes impact returns less on a percentage basis.

When constructing the equity portion of a tax-efficient investment model, vehicles such as ETFs and SMAs are typically used. While this may be a good start, there also may be opportunities to add tax-efficient alpha to portfolios by using active mutual funds.

We also believe dedicated, tax-efficient equity strategies could be considered. Long-term capital gains and dividends have preferential tax treatments, so looking for strategies with low turnover and/or a dividend-oriented strategy may improve tax efficiency.

Bottom Line

Fixed Income Considerations

  • Employ municipal bond strategies and state-specific bonds, particularly in high tax states.

Equity Considerations

  • Tax-advantaged investment vehicles such as ETFs and SMAs
  • Tax-efficient strategies
  • Active mutual funds with tax-efficient alpha

Our specialists are ready to discuss tax-efficient solutions

If you’re looking to incorporate tax efficiency into your investment models, we can help. Our Portfolio Construction Specialists work with financial professionals to find practical solutions for critical investment decisions.

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Additional Disclosures

Copyright © 2021, S&P Global Market Intelligence (and its affiliates, as applicable). Reproduction of any information, data or material, including ratings (“Content”) in any form is prohibited except with the prior written permission of the relevant party. Such party, its affiliates and suppliers (“Content Providers”) do not guarantee the accuracy, adequacy, completeness, timeliness or availability of any Content and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such Content. In no event shall Content Providers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of the Content. A reference to a particular investment or security, a rating or any observation concerning an investment that is part of the Content is not a recommendation to buy, sell or hold such investment or security, does not address the suitability of an investment or security and should not be relied on as investment advice. Credit ratings are statements of opinions and are not statements of fact.

©2021 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

After-Tax Returns

After-tax returns provide an estimate of a fund’s annualized tax- and load-adjusted total return for the time period specified. Morningstar’s data is consistent with the SEC’s 2001 guidance about after-tax returns, and it is updated as needed to reflect changes in the federal tax code. Taxes are a significant consideration for many investors who own mutual funds in taxable accounts. When a fund receives a stock dividend or interest from a bond, it will divide that dividend among its shareholders, and when a fund sells a security at a gain, it will divide that capital gain among its shareholders. Investors pay taxes on these dividends and capital gains, and they may also pay taxes on capital gains when they sell the fund. Investors can compare the total return, load-adjusted return, and after-tax returns for a fund to understand how loads and taxes affect the performance of the fund. Investors can also use after-tax returns to compare one fund to another. Morningstar calculates after-tax returns in-house on a monthly basis, using price and distribution data for each fund for different time periods. Morningstar calculates after-tax returns for open-end mutual funds, exchange-traded funds, and variable annuity underlying funds. This description applies to those funds that are domiciled in the United States.

Assumptions

The after-tax returns calculation is based on a few underlying assumptions that may cause the results to be slightly different than what each individual investor experiences. Per the SEC’s guidance, Morningstar uses the highest federal tax rate prevailing for each type of distribution. These results simulate the tax effects for an individual in the highest tax bracket. After-tax distributions are reinvested. State and local taxes as well as individual-specific issues are ignored. Per the SEC’s guidance about this topic, all after-tax returns are also adjusted for loads and recurring fees. Therefore, these are technically “tax- and load-adjusted returns” and not simply “tax-adjusted returns.” A fund’s after-tax return may be lower than its total return because of tax effects, sales charges, or both. Morningstar uses the maximum front-end load and the appropriate deferred loads or redemption fees for the time period measured. Sales loads are not applied to reinvested distributions. Morningstar applies the appropriate historical tax rate based on the date of the distribution. The current tax rates are as follows: 35% interest income and non-qualified dividends, 15% qualified dividends, 35% short-term capital gains, 15% long-term capital gains. For municipal bond funds, Morningstar will only adjust for capital gains taxes, as the income from these funds is generally exempt from federal tax.

Important Information

This material is provided for general and educational purposes only and not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. T. Rowe Price group of companies, including T. Rowe Price Associates, Inc., and/or its affiliates, receive revenue from T. Rowe Price investment products and services.

The views contained herein are those of authors as of August 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only.

All investments are subject to market risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Some municipal bond income may be subject to state and local taxes and the federal alternative minimum tax. Diversification cannot assure a profit or protect against loss in a declining market.

Portfolio construction services discussed are available only to financial professionals and not to the retail public.

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