Balancing Taxation with Investment Returns

There are those who don’t really focus on tax considerations with their investments very much, and there are also those who may focus on it excessively, often with the help of their investment advisors.

While these advisors may be have at least a basic understanding of the tax implications of various investment strategies, mostly focusing on the difference between tax treatment of different asset classes, such as stocks, bonds, interest income, dividends, and so on, there’s more to deciding between these asset classes of course than just the way their profits are taxed.

Balancing Taxation with Investment ReturnsOne must of course be careful to account for any interest that an advisor may have for you taking one course of action over another. People provide professional advice in various capacities, and often times the person giving the advice may be influenced by factors other than what may be objectively best for their clients.

If the advisor is employed by those who are selling the investments that he or she will be recommending, then the tax advice and other advice will naturally be a matter of choosing from among these offerings.

When we consult with an insurance representative, we may expect that the representative will be looking to sell us insurance, insurance provided by the company that they work for in fact. They may spend a good amount of time deciding which of their products will fit you, or they may not, but you can count on being offered something from their portfolio.

The financial services industry in general operates this way, and it would be naïve to think otherwise. Advisors may or may not be under a duty of care to their clients, and often they are not, but in the end, they are going to all have some sort of bias toward their own investments.

The upshot of this is that investors are well served to take a broader perspective on the alternative available to them, and in particular, be willing to educate themselves to at least the point where they are able to make a more educated decision about their investment strategy and not just follow the advice of others with few or no questioning.

Mixed in with whatever level of tax advise we get from people selling investments, is going to be a certain philosophy of investing, and we shouldn’t just assume a certain style is the best and then get our tax picture to fit into that, even though that is the primary goal of advising these days.

Mutual Funds Versus Individual Investing

Mutual funds have become enormously popular over the past few decades, and have risen almost to the point where they now have cult status, with many even believing that they are the only sensible way to invest these days.

It’s not that mutual funds are a bad idea, but they aren’t the only alternative for those who don’t want to design their own portfolios. It’s not that the people who run mutual funds beat the market by that much or even very often, and most fail at this. It is very difficult to move in and out of investments with the positions they have to take, and the fact that they are committed to having the majority of their funds long the market regardless of whether or not that is appropriate can certainly be a concern.

Mutual funds are not set up ideally for tax efficiency either, which may not seem like that big of a deal, paying tax from distributions when one is still invested, but this tax inefficiency can add up over the years.

When investments are sold, taxes become due on them if the sale resulted in a profit. Mutual funds buy and sell investments regularly, and someone must pay the tax on the profits from these investments, which means those who have profited, the investors of the fund.

However, we may just write that off to the costs of investing in mutual funds, as after all, do we want to make these decisions ourselves?  Given that few mutual funds beat the market though, the largest ones simply look to mirror the market by constructing index funds. These funds can be a little more tax efficient as they move in and out of positions less, but they still pass on distributions to investors as all mutual funds do.

If one is looking to decide what asset allocation would be best for them when investing in mutual funds, another question that needs to be asked is whether they are better off investing in mutual funds at all, versus going with a different type of investment.

While management fees drive part of this discussion, we also should look at what effect tax efficiency plays in this. Perhaps we would be better off investing in an index based ETF for instance, which have both lower fees and are more tax efficient.

ETFs are less managed and promoted though, so you may not get this advice from someone who specializes in mutual funds.

Returns Mean Net Returns

We also don’t want to overly weigh certain types of investments merely based upon the way their returns are taxed, for instance favoring income from qualifying dividends, from domestic public companies, just because you may pay less per dollar returned.

Tax efficiency is certainly part of the discussion though, to the extent that it impacts the bottom line, our expected net return from an investment. If the expected return is considerably less with a more tax efficient investment, this does not mean that it is preferable, as the higher return of a competing investment may yield a significantly higher net return.

This is only common sense, but it isn’t uncommon for investors to put too much weight on tax efficiency rather than just seeing it as one component of net return. If you are paying less tax from a certain investment but are getting less of a return in the end once this tax difference is accounted for, deferring more tax can end up being the poorer choice.

You will often see things like the necessity to maximize your tax efficiency within your portfolio as if it was a fundamental concern in itself. Even though this will include considerations of tax sheltering, which certainly can contribute significantly to one’s overall long-term tax picture, all these concerns are only a part of the overall plan, which can never merely seek maximum tax efficiency.

Tax efficiency needs to be treated alongside expected gross returns, such that we may expect that one strategy involving a combination of both elements will produce a higher expected net return overall.

Balancing Taxation Concerns with Investment Risk

An even more important concern is balancing risk with tax efficiency. While most investors are well aware of investment risk, most still underestimate the importance of risk management, often grossly underestimating its importance.

While it is imprudent to allow for tax considerations to overly guide us, it is also unwise to let even expected net return dominate our strategies. All of these decisions have to be made in the context of risk, and risk here just doesn’t mean how much your investments may lose before you lose sleep, get upset and sell them inappropriately, or other subjective considerations.

This is the way the industry approaches risk though, they tell you that you should be comfortable taking on a lot of risk and that you need to stay the course, their course, and if you can’t handle the heat then perhaps a less risky investment would be preferable.

One’s comfort level does matter of course, but whether we are comfortable with excessive risk or not, inappropriate amounts of risk for our situation and objectives, in these cases it is still excessive, objectively.

If someone has all of their investments in the stock market for instance and does not have the investment horizon to ride out the larger ups and downs that these investments produce, then this strategy is simply too risky, period, whether or not one is happy or comfortable with taking on the extra risk involved.

Whether or not one will receive tax breaks on the profits doesn’t really change this. Having to sell at a loss will be even more tax efficient, as taxes are not due when you lose money.

This is one of the real risks of being over preoccupied with tax efficiency, when this ends up guiding us down what is the wrong path when all things are considered. The ability to manage risk, and even the level of risk itself that is involved, still needs to be taken well into account.

We may even wonder whether it is wise at all to be committed to being long investments regardless, as a good argument can be made that this strategy pays far less attention to risk management than would even be sensible.

It is clear though that under certain circumstances at least, when one’s ability to handle these risks is diminished, that we surely need to be heeding these risks and well accounting for them when deciding on our investment strategies.

Regardless of which path we choose, we must always be aware of all three of the major elements in constructing an investment plan, which does include tax considerations, but also includes expected return as well as properly accounting for the risks involved.

It is only when we consider all of this that we can correctly compare different strategies and courses of action to look to decide which may be in our best interests overall.



Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: [email protected]

Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.