My favorite quote on taxes comes from Morgan Stanley…

“You must pay taxes, but there’s no law that says you have to leave a tip.”

Recently, we met a prospective client that was baffled how her advisor generated a large taxable event…

“I never sold a single stock… so why do I owe taxes?”

We pull back the curtain and highlight how advisors create tax bombs for their clients and how you can avoid punting cash to Uncle Sam.

Selling Investments for a Gain (the most obvious)

When you sell a stock, ETF, or mutual fund for more than you paid, the transaction can trigger a capital gain.

Creating a capital gain isn’t a taxable event in and of itself.  It’s only a taxable event if the realized gain exists on 12/31.

• Short-term gains (held ≤ 1 year) are taxed at ordinary income rates.
• Long-term gains (held > 1 year) are taxed at lower capital gains rates (15-20% federal).

How to mitigate or avoid…

• Look for unrealized losses to offset realized gains prior to year-end (also known as tax-loss harvesting).
• Sell the most tax friendly “lots”. For example, selling 100 Apple shares that were purchased in 2017 will generate a larger taxable event than selling 100 Apple shares that were purchased October 2024.
• If you are going to realize capital gains, do it early in the year. You’ll have the entire calendar year to capture losses to offset the gain.

Here’s a primer on how Pure Portfolios reduces capital gains for clients…

How to Reduce Capital Gains in your Portfolio

Automatic Mutual Fund Distributions

Mutual funds often distribute capital gains, dividends, and interest income at year-end. Most fund companies will announce the distributions in the 4^th quarter.

Here’s the kicker; an investor would owe taxes on the distribution despite not selling a single share.

The distributions are taxed in the year received, even if they’re automatically reinvested. In a non-retirement account, these distributions can create an unexpected tax bill.

This isn’t limited to active mutual funds that constantly buy & sell securities attempting to beat a benchmark.  Passive, low-cost index mutual funds can be just as bad (Vanguard pays $100 million penalty due to taxable distributions).

The archaic structure of mutual funds is why many fund companies are transitioning to ETFs (Mutual Funds Bleed Another $432 billion as ETF Conversions Grow).

If an investor or advisor has a choice, ETFs are almost always the superior vehicle.  An obvious exception is within your employers 401k plan, which almost exclusively offer mutual fund options.

How to mitigate or avoid:

• Avoid mutual funds in taxable accounts
• If your advisor invests in mutual funds within a taxable account, find a new advisor (Pure Portfolios does not invest in mutual funds).

Dividend Investing

Dividend investing is a great feature of investing in stocks. However, targeting dividend paying stocks in a taxable account could leave you with a large tax bill.

There’s no way for an investor to shelter dividend income from taxes in a non-retirement account.

• Qualified dividends are taxed at long-term capital gains rates.
• Non-qualified dividends are taxed at ordinary income rates.

How to mitigate or avoid…

• If you prefer dividend paying stocks, it’s best to own them in a tax-advantaged account i.e. IRA, 401k, Roth.

Interest Income from Bonds or Bond Funds

Interest from taxable bonds i.e. corporate bonds, U.S. Treasuries, money market, high-yield bonds is considered income within a taxable account.

The income is taxed as ordinary income rates in the year it’s earned.

How to mitigate or avoid…

Pure Portfolios has developed a proprietary tool that evaluates a client’s Fed & state tax rate and current bond yields to determine which mix of bonds maximizes after-tax returns (taxable bonds vs. municipal).

Source: Pure Portfolios

The above calculator evaluates municipal bond yields, federal & state tax rates, and comparable taxable bond yields. The output on the right shows which style of bond helps the client maximize after-tax returns.  In the above example, municipal bonds make the most sense after considering the client’s Fed/state tax rate.

Asset Location (or lack thereof)

Let’s say Bertha has $1 million dollars equally spread across Roth, Traditional IRA, and a taxable account.

Bertha and her advisor have determined the appropriate allocation for her risk profile is 50% stocks & 50% bonds.

The advisor happily invests 50% of the Roth, Traditional IRA, and taxable account in stocks and does the same for the bond allocation.

Seems straightforward, right?  Wrong.

The advisor is likely generating unnecessary taxable income and stunting the tax-free, tax-deferred growth characteristics of the Roth account.

How to mitigate or avoid…

• The Roth account should be the most aggressive to maximize tax-free growth. A large, tax-free pile of money is valuable; therefore, we do not want to own conservative investments in a Roth.
• The IRA can be right in-line with Bertha’s 50/50 allocation target.
• The taxable account should be slightly more conservative with a sensitivity to taxable interest or dividend income.
• Despite the varying levels of risk by account type, when we evaluate Bertha’s allocation at the household level (factoring in Roth, IRA, and taxable accounts), it’s right in-line with her risk profile, but much more tax-efficient.

The Exotic and Confusing

In the past 10+ years, many Wall Street advisors have pushed exotic private equity, hedge funds, master limited partnerships, and private real estate deals.

Instead of the traditional 1099, many alternative investments issue a Schedule K-1, which reports each owners share of pass-through income, losses, deductions, and credits.

This often creates confusion, complexity, and delays for clients looking to file their taxes.

• K-1’s often arrives late (March or later), delaying tax filing.
• You had better have a good CPA. Complex rules around passive activity losses and unrelated business taxable income (UBTI) make doing your taxes a nightmare. State-level tax filings may be required if the investment operates in multiple states. The result is having to file state returns for multiple states (again, good luck to your CPA & it’s going to cost you additional tax prep fees

How to mitigate or avoid…

• Know what you’re getting into before investing in exotic, alternative vehicles
• Have a superstar CPA
• Best of all, avoid confusing, illiquid, and expensive alternative assets.  In our opinion, simple beats complex.

Investing is hard. Don’t make it harder by tipping money to Uncle Sam.

If your advisor has saddled you with a massive, unexpected tax bill, shoot us a note at insight@pureportfolios.com.