How tax aware investing can help improve after-tax returns

Tax-aware investment management plays an important role in helping preserve and growing wealth over time. While many investors focus on market performance and investment selection, the impact of taxes is often just as significant. Even strong returns can be meaningfully reduced if taxes are not managed carefully. By incorporating tax-efficient strategies into a portfolio, investors may be able to improve what they ultimately keep after taxes.

One of the most commonly used strategies is tax loss harvesting. This involves intentionally realizing losses within a portfolio to offset gains realized elsewhere. For example, if an investor sells one investment at a gain, they may also sell another investment that is currently at a loss to reduce the overall taxable gain. By doing so, the net tax liability may be lowered without necessarily changing the long-term investment strategy.

If losses exceed gains in a given year, up to $3,000 of those losses can generally be used to offset ordinary income. Any remaining losses may be carried forward to future years and used to offset gains later. This creates a longer-term benefit, as losses harvested today can continue to provide tax savings over time.

Tax loss harvesting is often most effective during periods of market volatility. Market declines may create opportunities to realize losses while maintaining similar market exposure. In many cases, an investor can sell one investment and reinvest in a similar, but not identical, position to stay aligned with their overall allocation. However, investors must be mindful of the wash sale rule, which generally disallows a loss if the same or substantially identical investment is repurchased within 30 days.

Another important factor in tax-aware investing is the timing of gains. Investments held for more than one year are typically eligible for long-term capital gains treatment, which is often taxed at lower rates than short-term gains. Being mindful of holding periods before selling appreciated investments can sometimes lead to meaningful tax savings.

Investors should also be aware that certain mutual funds may distribute capital gains to shareholders when securities are bought and sold within the fund. These distributions can create a tax liability even if the investor has not sold their own shares. In addition, actively managed mutual funds often carry higher expense ratios than passive ETFs, which can further reduce net returns over time. As a result, some mutual funds may be less tax efficient in a taxable account, particularly if they have higher turnover.

Beyond managing ongoing portfolio activity, tax-aware strategies can also play a critical role when planning for significant future liquidity events. The sale of a business, real estate or a concentrated investment position can create substantial capital gains. In these situations, proactive planning may help reduce or defer the associated tax burden.

One approach that has gained traction is direct indexing. This strategy involves owning individual securities that replicate the performance of an index, rather than investing through a pooled vehicle. By holding the underlying securities directly, investors have more flexibility to harvest losses throughout the year, even when the overall index is positive. This can create a steady stream of tax losses that may be used to offset gains from other sources.

A more advanced variation, sometimes referred to as long short direct indexing, takes this concept further by incorporating both long and short positions. This structure may help enhance the ability to generate tax losses while maintaining desired market exposure. While more complex, these strategies can be particularly valuable for high-income investors or those anticipating large capital gains.

For investors planning the sale of highly appreciated assets, other deferral strategies may also be considered. Opportunity Zone funds allow investors to reinvest capital gains into designated projects, potentially deferring the original gain and, in some cases, reducing or eliminating taxes on future appreciation if certain holding requirements are met.

Similarly, Delaware Statutory Trusts, often referred to as DSTs, are sometimes used in real estate transactions as part of a like kind exchange strategy. These structures may allow investors to defer capital gains taxes on the sale of investment property by reinvesting proceeds into qualifying replacement property interests.

Each of these strategies comes with specific rules, risks and time horizons. They are not appropriate for every investor, but when used thoughtfully, they can provide meaningful opportunities to manage or defer taxes associated with large, planned gains.

It is important to recognize that tax strategies should support, not drive, investment decisions. Selling an investment solely for tax reasons without considering the broader plan may lead to unintended consequences. Instead, tax-aware investing works best when it is integrated into a disciplined, long-term approach.

Over time, consistent tax management within a portfolio can have a compounding effect. Reducing taxes in one year leaves more assets invested, which can continue to pursue growth and help generate returns in future years. While the benefit in any single year may seem modest, the long-term impact can be significant.

Ultimately, tax-aware investing is about improving efficiency. Investors may not be able to control market returns, but they can often influence how and when taxes are incurred. By combining strategies such as tax loss harvesting with thoughtful planning around future liquidity events, investors can position themselves to retain more of what they earn and build wealth more effectively over time.

Reid Schwartz is a columnist for The Item and co-founder of Creech Schwartz Wealth Management in Sumter, where he works as a financial advisor helping individuals, families, businesses and nonprofits plan for long-term financial success.

* Tax and accountancy services are not available through or provided by Creech Schwartz Wealth Management or &Partners LLC.

This article is for educational purposes only and not to be interpreted as tax or legal advice. Any tax planning strategies discussed by Creech Schwartz Wealth Management will be in conjunction with your tax/legal professional.

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