A Primer on Tax-Efficient Investing Strategies

Anu Rajakumar: For most investors, the number that matters most isn't what a portfolio earns, it's what they keep after taxes. Over decades, the gap between the two can add up to a surprisingly large share of long-term wealth. Lately, that gap is getting more attention thanks to a combination of market moves and technological innovation. A long bull market has left many investors with significant embedded gains and outsized single-stock positions. At the same time, technology has made tax-aware strategies far more accessible, and regulators are watching all of this with a close eye.

My name is Anu Rajakumar, and today I'm joined by Doug Kramer, head of Institutional Equity and Multi-Asset at Neuberger. Doug and I will be talking about what's driving demand for tax-efficient investing, the tools available, how to manage concentrated positions, and the pitfalls that all investors should understand. Doug, welcome back to the show.

Doug Kramer: Thank you, Anu.

Anu: Well, Doug, we've had a long equity bull market, and a lot of investors are sitting on significant unrealized gains. Let's start by just putting some numbers on that. Tell us about the sheer size of this.

Doug: The amount of wealth that's been created in the last 15 years is truly staggering and probably unprecedented. US household net worth has more than doubled since 2010, rising from $65 trillion upwards of $180 trillion today. Families and individual investors are sitting on low-cost-basis stock positions with massive amounts of unrealized capital gains--often very, very concentrated in less than 10 stocks. People are very interested in techniques, that can help them manage those taxes.

Anu: There are some staggering numbers there. Let's talk about this in a little bit more detail, dig into it a little bit. Why is it getting so much attention then right now?

Doug: It's getting attention because of the power of compounding and an educational campaign that's gone on to show people techniques that will allow people to defer taxes. I'll give you an example to put it into perspective. I've always been fascinated with compounding. When I talk to my kids about compounding, the power of compounding is really powerful. Let's say you started out with $10 million and you had an 8% pre-tax return over 30 years. Through the power of compounding, that $10 million would turn into almost $100 million. If you had a 1% tax drag over that period, meaning every year you would sell a little bit of your portfolio to rebalance it or do anything and it dragged on taxes, you would lose almost $26 million to taxes. Instead of having $100 million, you'd have closer to $75 million or $74 million. If you actually had a 2% tax drag instead of a 1% tax drag, that $100 million turns into $57 million. As our industry has educated people on the actual true economic drag of taxes, people become much more cognizant about delaying or deferring tax.

Anu: Actually, that's a really important backdrop and that power of compounding is so critical here. Before we get into those specific tools, let's make sure we're just using the same language. You've mentioned these words tax efficiency, and want to make sure that we're clear on how is that different from tax avoidance?

Doug: Let's start with the obvious. Tax avoidance is not something you can do, but there are things you can do all within the boundary of the tax code that Congress wrote. For example, when you pay your taxes, what your tax rate is, and where you hold those assets.

It's also not free money, meaning most of what we do is about deferral. It's about taking your tax bill and pushing it out into the future. It's like Finance 101, you want to receive your money now and pay people later. By doing so, you can create value. Your taxable gain is still there, it's just you pay it later. Obviously, you can have a step up upon death. We're not talking about that.

I'll give you another example. if you had $1 million of a tax liability that's due today, and instead of paying it today, you paid it in 10 years. If you looked at the 10-year Treasury rate today, it's 5%. If you invested $1 million in a US Treasury for 10 years, you'd get a $50,000 coupon every year. At the end of 10 years, you'd have $1.5 million. Deferring that tax lets you keep the money and lets it work for you.

Anu: I think that's a really important framing. With that in mind, let's talk about the toolkit that's available. What are the main tax-efficient approaches that investors have at their fingertips today, and how has access to those changed in recent years?

Doug: There are three buckets that we would say in terms of strategies for tax-efficient investing. There are what we call core equity strategies, there are strategies that deal with concentrated and low-cost-basis stock, and there are some other income and liquidity tools. Let's start with the first one, which is tax-loss harvesting strategies. Investors can harvest losses and let gains defer. Those losses can be used to offset other gains, which, in fact, defers taxes. You can do that on a long-only basis. You can do that in a long-short basis, which means borrowing money and shorting stocks to create more value add.

Then the other thing that's very tax-efficient today are exchange-traded funds or ETFs. You've seen them grow rapidly. There are certain mechanisms inside an ETF that allow portfolio managers to rebalance those securities without incurring tax. Then other things that are available to taxable investors are exchange funds, which is where you contribute securities into a fund and receive it back later in a basket of stocks.

There's another thing called a 351 exchange, which allows investors to contribute stock into an ETF. There are very specific rules around how you go about that. We might talk about that later. Then there's another technique called a prepaid variable forward, which is essentially collaring, through an options trade, a single stock, and being able to borrow money against that to use for other purposes. That actually doesn't get you out of a stock, it just sort of defers the tax.

Then lastly, on the income and liquidity side, municipal bonds are very tax-efficient. We also do options overlay with tax-efficient index options that can help people lower their tax bill. Then there's another technique called box spread borrowing, which allows people to, in a way, borrow money at a very tax-advantaged position. All of these things are now available to investors because of technology, because of access, because of education.

Anu: Okay. There's quite a suite of tools available to investors. I want to dig into one of the areas that you mentioned, which is concentration, which, as many know, is historic highs in various indices. A lot of investors are seeing the same thing in their own portfolios, which is maybe a single stock that they bought years ago, which really dominates their own portfolios today. What options do they have for managing these large low-basis positions?

Doug: Yes. Let's take a step back. With a single-stock position, you can sell it and pay the tax, you can hedge it, which means you're just hedging it, but you're not getting rid of it, or you can diversify with some of the techniques that we'll describe. Exchange funds have been a long-term popular strategy, where a client will contribute their stock into a fund where other investors contribute their low-cost basis stock, and essentially the aggregator takes stocks that are in a diversified manner from different sectors, different industries, and tries to get broad market exposure.

The problem with exchange funds is that most people have the same stock. Think about Google, Microsoft, Tesla, Facebook, all the wealth that's been created in tech, everybody wants to contribute the same stock, so it really doesn't work. There are also some specific rules there that lock you up for seven years. Sometimes they're high fees. The strategy that I really like is to take a concentrated stock position and pair it with a long-short tax loss harvesting strategy. Why do we do this? Over time, the long-short tax loss harvesting strategy will try to beat the market or exceed the market on a pre-tax basis.

It's really important to note that there is an economic reason for entering into this long-short strategy. It's, can we exceed the market on a pre-tax basis? but on an after-tax basis, these funds can throw off pretty sizable losses in any given year. What investors can do is measure the losses in their long-short portfolio, look at their single-stock position at the end of that year, chip away or pare down that position, and then move to year two, do the same thing again, harvest the losses in the long-short portfolio, sell a little bit more of that large single-stock position. Over the course of one, two, three, four, five years, you can pare down that single-stock position while deferring the tax into the future.

Anu: Very innovative. Those are very helpful to hear about some of those options. Maybe let's talk about some of the trade-offs or the downsides to all of this. Before folks look to optimize their taxes, what do you think investors really need to understand about these strategies?

Doug: The first thing is that don't let the tax tail wag the investment dog, if you follow me. Meaning tax efficiency should serve your investment objectives, not replace them. A portfolio that saves tax but blows up your risk profile or creates a whole set of other risks really doesn't do anything. The second thing is that taxes are tricky. You need to consult your advisor. You need to talk to your accountant. You need to look at your whole portfolio. It's not really about what strategy is best for you, it's what solution is best for your situation. Everybody has a different tax situation. Everybody has an idiosyncratic story.

A long-short tax loss harvesting strategy could be combined with an option strategy, which could be combined with a box spread financing strategy. It all depends on your circumstance, but the idea that you're going to go out and find a magic bullet with one strategy and that's going to solve your situation--typically it will not. You really need to take a step back.

It's complicated, but the nice thing is that there are techniques that are legal and effective to, in a sense, defer the tax. I repeat, we are not avoiding tax, what we're trying to do is harvest losses and do other techniques that allow you to push your tax liability as far out into the future as you can, which creates an economic benefit in the near-term.

Anu: Yes. I like what you said there, that there's maybe not one solution that fits everyone, but there are lots of ranges of solutions that can be customized depending on folks' specific situations. There's also a regulatory dimension here. I know it's moving quickly, so we don't have all the answers or solutions here, but I did want to mention that US Treasury, IRS, they recently moved to limit some tax-aware strategies and they flagged others for review. In plain terms, what does this greater scrutiny really mean for investors?

Doug: It's a fast-moving situation and there are a lot of nuances to this. I'll do my best to describe how we understand it. There are some strategies that the IRS has looked at very carefully, strategies that generate ordinary income losses that they have flagged as being somewhat aggressive. I can't opine on how aggressive they are, but those strategies would offset ordinary income, which is quite attractive. Might be too good to be true, obviously.

There was also another comment about an ETF that does a specific box spread investing strategy, where that ETF essentially turned ordinary income into long-term capital gains. That's under a bit of scrutiny. I would say this, what they didn't say or what they were silent on are things like ETFs, using custom-in-kind baskets, and using that technology to be more tax-efficient. They didn't comment on exchange funds properly run. They didn't comment on tax-loss harvesting strategies or tax-aware investing.

They did acknowledge that tax-loss harvesting is a longstanding technique that investors have used for decades. I'd even comment now today that with interest rates up, a lot of people are sitting on losses in their fixed income portfolios. I wouldn't be surprised to see people exchanging bond A for bond B to harvest a loss.

The one other transaction that they also have looked at are 351 exchange transactions. I mentioned that earlier. The key here is that when you contribute a security into an ETF with a 351, the securities that you contribute have to be acceptable to the portfolio manager, they have to be consistent with the investment strategy, and they have to be held in that ETF for quite some time. I think there are market participants that have taken very aggressive stances of taking securities-in-kind into a 351 and making some quick trades to potentially defer taxes more aggressively than the IRS had thought.

Anu: Great. Thank you very much. I think that's a good picture of where things stand today. Of course, the situation is fluid and we don't have all the answers. Let's finish by looking ahead. Doug, how do you see tax-efficient strategies evolving from here, and for the investors listening, what's one takeaway that you'd like to leave them with?

Doug: Yes. Faster, cheaper, better technology is allowing investors to access strategies that were heretofore available for the ultra-high net worth. So transaction costs have come down, the ability to optimize and trade the portfolio to generate pre-tax returns and after-tax returns has gone way up.

I would say this, and I repeat what I said before, which is, it's not really, ‘What strategy is best,’ it's, ‘What problem are you trying to solve for?’ Is it a concentrated position? Is it a liquidity event? Start with the problem and your whole balance sheet, and then match the strategy, understand the trade-offs, and bring your tax advisor in early, and always follow the rules. in the context of pre-tax investing and after-tax investing, what matters is what you keep, not what you earn on a pre-tax basis.

Anu: Absolutely. Thank you very much for sharing all those comments. I can't let you go without a quick bonus question, Doug. I know that you're passionate about sports, and in fact, you sit on the advisory board of the University of Pennsylvania Athletics. I'm curious to know, what does sports mean to you in your personal life, or what's one life lesson that you've learned from sports?

Doug: That's a great question. I love sports. I love competition. I think sports teaches you resilience, it teaches you perseverance, and it teaches you how to win or lose. That serves you well in everything you do because you don't win them all, so you have to keep your head up at all times.

Anu: I agree. Resilience is one of the best lessons that we all learn from sports. Thank you very much for your time today. I appreciate a lot of the things that you said today. To summarize a few of them, we talked about how a number of investors are really focused on diversifying their portfolios but fearful about a large tax bill given significant unrealized gains that they've experienced over the last number of years. We talked about the power of compounding and how there could be some really big differences depending on your tax drag levels.

We talked about tax efficiency as about really using the rules as intended. You also mentioned that concentrated positions don't have to mean an immediate tax bill. We talked about the technology that's really put tools in the hands of the investors that were once out of reach for many investors. I want to just-- one final point that you mentioned, which is for investors to really understand what problem that they're really trying to solve for. I love this quote that you said, “don't let the tax tail wag the investment dog.” That's the quote that I'll leave our listeners with. Doug, really appreciate your time. Thank you for being here today.

Doug: Thank you, Anu.

Anu: To our listeners, if you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes as well as more information about our firm and offerings.