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Investment Theory and Portfolio Development - Tax Efficiency

A tax-efficient portfolio throws off income while at the same time minimizing taxes. Efficiency is obtained in several ways.

  1. Turnover - the greater the amount of turnover in a portfolio, the greater the frequency with which taxable gains are generated which, in turn, along with the resultant transaction costs, decrease portfolio returns.
  2. Timing of capital gains and losses - occurs either to generate capital losses to offset taxable income at year end or to defer the payment of tax until the following calendar year.
  3. Wash sale rule - a tax rule which states that investors may not use capital losses to offset capital gains or income if they sell a security at a loss and purchase the same or substantially identical security[Examples are the purchase of call options, rights, warrants, convertible bonds or the sale of deep in-the-money puts of the same issuer.] within thirty days before or after the initial trade which created the loss. The wash sale is the sale and repurchase within the aforementioned period. The rule is applicable to realized losses rather than gains. To avoid the same or substantially identical security rule for bonds, the investor may change at least two of the following three items: issuer, coupon or maturity.
  4. Qualified dividends - In order to be taxed as a qualified dividend, the investor "must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date," (IRS Publication 550). The maximum rate on such dividends is 15%, rather than the ordinary income tax rate for individual investors.
  5. Tax-free income - is income that is exempt from federal, state or local income tax. Municipal bond income is exempt from federal income tax; income from treasury notes and bonds is exempt from state and local, but not federal income tax. Chapter One discusses the analysis necessary for municipal bond investors to conduct to determine if the purchase of municipal bonds is prudent. As a general rule, the higher the individual's marginal tax bracket, the greater merit a municipal bond purchase would have, ceteris paribus, as s/he would be afforded the opportunity to realize greater tax savings.
Performance Measures

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