“The collection of taxes which are not absolutely required, which do not beyond reasonable doubt contribute to the public welfare, is only a species of legalized larceny.” - Calvin Coolidge, 30th President of the United States
We thought it would be fun to discuss how to maximize your tax bill. That's right, let's write a big fat check to Uncle Sam for no good reason. If we tell someone their portfolio has loose ends, it might resonate, it might not. If we tell them how to Drive Their Portfolio into the Ground and they take a look under the hood and see they're doing just that, it might compel action.
One of the most common mistakes we see from prospective clients is tax-inefficient portfolios. It's an epidemic, however, we're convinced it's not their fault. Many of these portfolios were built by financial advisors without formal training in portfolio management.
The below is a summary of the worst advice we could give someone trying to build a tax-efficient portfolio. As Charlie Munger* would say, "Invert, always invert."
Ignore Asset Location
Your mix of stocks and bonds are exactly the same across account registrations. For example, a 50/50 (stocks/bonds) investor who owns the same allocation across Roth, Traditional IRA, and taxable accounts.
Bonus Points: Have no clue what your asset allocation is.
Trade, A Lot
Never consider cost basis when making allocation changes. Tax-loss harvesting is for losers.
Bonus Points: Make emotional decisions. Follow the market daily. Don't have a formal process for managing risk. Be reactionary.
The More, the Merrier
Have many investment accounts spread across financial institutions. Be unable to tell how you're invested. Accumulate cash in forgotten 401ks & IRAs.
Bonus Points: Every tax season leaves you scrambling to gather 1099s from a dozen financial institutions.
The Bigger, the Better
Insist on working with the biggest financial institutions. You want an advisor so overloaded with client accounts, they can't possibly understand your individual tax situation.
Bonus Points: Your advisor works in a call center getting bombarded with hundreds of calls per day.
Maximize Portfolio Income
Target high income producing strategies in taxable accounts. Think high yield bonds and dividend strategies. You enjoy paying taxes on every dollar of portfolio income.
Bonus Points: Even better if you have a high Federal tax rate and live in an state with income taxes.
Keep it Complex
Buy exotic investment vehicles that trigger K-1s. Keep your CPA guessing and test their expertise. Commodity funds are perfect for this.
Bonus Points: Delay your tax filing while waiting for a K-1.
Shun Everything, but Mutual Funds
Insist on only investing in mutual funds, especially in taxable accounts. You'll enjoy the surprise of random tax bills. Even better if the fund triggers capital gains in a down year (2015 & 2018 being the most recent examples).
Bonus Points: Pretend those capital gains distributions are tax-exempt, special dividends.
Pay No Mind to Your 1099, That's Just Paperwork
Don't ask questions. Your advisor has your back. Paying taxes is part of investing. There's no way around it.
Bonus Points: Your 1099 is made available at the last minute.
Obviously, we wouldn't recommend doing any of the above. We understand that investing is hard and it's important to take the low-hanging fruit. The difference between a tax-efficient portfolio and a rudderless, leaky portfolio could be up to 2.5% per year (source Barron's Feb. 1st edition)! We're talking potentially hundreds of thousands or millions of dollars gifted to the U.S. government that could be avoided with sound portfolio management practices. For more on how you can tidy up your portfolio and reduce your tax burden, check out our case study, "Is Your Asset Location Costing You?" You can read about our buddy Cecil who reduced his potential tax burden by ~$130,465 over a 10-year period!
*Charlie Munger is Warren Buffett's long-time business partner. Charlie often states the best way of solving a problem is looking at it from the opposite point of view.