by Kevin Peacock | July 19, 2024 | Articles, Investments, Taxes
The traditional goal in building portfolios, as described in Modern Portfolio Theory, is to maximize return for a given level of risk, but this only provides part of the picture for an individual investor. Managing tax efficiency also plays a major role, as improving after-tax returns increases the amount available to spend from an investment portfolio. At the end of the day, as the saying goes, “It’s not what you make, but what you keep” that matters most. This article addresses a variety of tax considerations in portfolio construction, such as the asset location of traditional investments, a strategy for investors with significant tax losses from tax loss harvesting, and an overview of the tax treatment of alternative investments.
As an individual investor, you have the opportunity to optimize your after-tax return by leveraging three different types of investment accounts: taxable (or brokerage) accounts, tax-deferred accounts (e.g., a pre-tax IRA or 401(k)), and tax-exempt accounts (e.g., a Roth IRA or Roth 401(k)). Utilizing an asset location strategy is a powerful tool that allows you to treat all account types in a household as one portfolio, thereby minimizing the tax cost of holding a given investment portfolio.
The following is a high-level prioritization by account type for tax location purposes:
The tax treatment of bonds can get complex, but the key points are as follows:
The following pre-tax yield would be required to net 3% after-tax to an NYC taxpayer¹ with $1M taxable income (regardless of filing status):
Emphasizing fixed income in retirement accounts often makes sense, given that you could place the highest yield bonds without considering current-year taxation (tax-free municipal bonds are almost always significantly lower yielding than taxable bonds due to their preferential tax treatment). That said, the time horizon for the use of funds is also important. For example, suppose an investor is in their 30s and looking to fund a significant purchase in 3-5 years. In that case, you may prioritize holding fixed income in a taxable account to better match the risk of that account with the time horizon for reaching a given goal.
To better quantify the tax efficiency of various equity ETFs and mutual funds, we gathered data on historical dividends, the proportion of qualified (long-term capital gains tax rates) vs. non-qualified dividends (ordinary income tax rates), 199A dividends (20% QBI deduction), and foreign tax credits where applicable. This data collection is crucial in understanding the tax implications of these investment options.
As a secondary factor for ETFs with similar tax costs, ETFs with higher expected volatility provide increased potential for tax loss harvesting. Conversely, low-volatility assets are less likely to offer this opportunity.
The following shows data for an NYC taxpayer with $1M taxable income that would be taxed on the next dollar earned from distributions on the following list of funds. (All filing status would have the same marginal tax rates based on the current brackets for Federal, NY, and NYC):
| Ticker | Name | Average Annual Tax Cost % (2018-2023) | Average Annualized Volatility (2018-2023) |
| DFAT² | Dimensional U S Targeted Value ETF | 0.56% | 26.42% |
| IJR | iShares Core S&P Small-Cap ETF | 0.56% | 25.21% |
| IJH | iShares Core S&P Mid-Cap ETF | 0.58% | 23.43% |
| IVV | iShares Core S&P 500 ETF | 0.63% | 19.50% |
| IJJ | iShares S&P Mid-Cap 400 Value ETF | 0.69% | 24.60% |
| DISV² | DFA International Small Cap Value ETF | 0.81% | 18.09% |
| IEFA | iShares Core MSCI EAFE ETF | 0.98% | 18.52% |
| IEMG | iShares Core Emerging Markets ETF | 1.01% | 20.99% |
| DFEV² | DFA Emerging Markets Value ETF | 1.12% | 16.34% |
| DEMSX | DFA Emerging Markets Small Cap | 1.46% | 15.64% |
An investor could hold the index’s underlying sectors tax-efficiently further to optimize the tax efficiency of S&P 500 holdings.
| Ticker | SPDR Sector ETF | Average Annual Tax Cost % (2018-2023) | Average Annualized Volatility (2018-2023) | S&P 500 Weight (07/15/24) |
| XLC | Communication Services | 0.32% | 23.25% | 9.10% |
| XLY | Consumer Discretionary | 0.36% | 24.02% | 10.02% |
| XLK | Technology | 0.40% | 25.76% | 32.97% |
| XLV | Health Care | 0.63% | 17.24% | 11.5% |
| XLI | Industrial | 0.63% | 21.53% | 8.08% |
| XLF | Financial | 0.71% | 24.11% | 12.57% |
| XLB | Materials | 0.75% | 22.67% | 2.16% |
| XLP | Consumer Staples | 0.97% | 15.74% | 5.62% |
| XLU | Utilities | 1.10% | 20.84% | 2.24% |
| XLRE | Real Estate | 1.55% | 22.71% | 2.18% |
| XLE | Energy | 1.83% | 33.55% | 3.56% |
When constructing the portfolio, it’s usually best to emphasize low tax efficiency and high expected return assets in Roth. Examples from the above include DFA Emerging Market Small Cap (DEMSX), XLRE, and XLE. Since utilities are traditionally considered lower expected return equities, it could make sense to emphasize this holding in a pre-tax retirement account. However, this also depends on the relative balances across each account type.
When a taxpayer has significant tax losses, options-based strategies can be employed to increase tax efficiency further. Utilizing exchange-listed index options subject to marked-to-market 1256 treatment (60% long-term and 40% short-term) can create a broad array of exposures, typically subject to capital gains tax treatment with no dividends or interest paid.
The following is an example scenario (pre and post-tax) of three portfolios (based on 07/16/24 at 2:20 PM ET data):
Assumptions Used for All Scenarios (based on data obtained on 7/16/24 at 2:20 PM ET)
| S&P 500 Index Level 1 in 1 Year 7/17/25 | Unchanged Price | +10% Price | -10% Price |
| Initial S&P 500 ETF Investment | $565,216 | $565,216 | $565,216 |
| Percentage in S&P 500 ETF | 25.48% | 25.48% | 25.48% |
| Initial 1-Year Treasury Investment | $1,653,493 | $1,653,493 | $1,653,493 |
| Percentage of Portfolio in Treasury | 74.52% | 74.52% | 74.52% |
| Profit after 1 Year S&P 500 ETF | $6,839.11 | $ 63,360.71 | $ (49,682.49) |
| Profit after 1 Year Treasury Bond | $81,021.16 | $81,021.16 | $81,021.16 |
| Total Profit After 1 Year | $87,860.27 | $144,381.87 | $31,338.67 |
| Pre-Tax Return | 3.96% | 6.51% | 1.41% |
| Tax-Cost Treasuries³ | -1.49% | -1.49% | -1.49% |
| Tax-Cost S&P 500 ETF Exposure⁴ | -0.16% | -0.16% | -0.16% |
| After-Tax Return | 2.31% | 4.86% | -0.24% |
| S&P 500 Index Level 1 in 1 Year 7/17/25 | Unchanged Price | +10% Price | -10% Price |
| Initial S&P 500 ETF Investment | $565,216 | $565,216 | $565,216 |
| Percentage in S&P 500 ETF | 25.5% | 25.5% | 25.5% |
| Initial NY Muni ETF Investment | $1,653,493 | $1,653,493 | $1,653,493 |
| Percentage of Portfolio NY Muni | 74.5% | 74.5% | 74.5% |
| Profit after 1 Year S&P 500 ETF | $6,839.11 | $63,360.71 | $(49,682.49) |
| Profit after 1 Year NY Muni | $53,242.47 | $53,242.47 | $53,242.47 |
| Total Profit After 1 Year | $60,081.59 | $116,603.19 | $3,559.99 |
| Pre-Tax Return | 2.71% | 5.26% | 0.16% |
| Tax-Cost NY Muni ETF | 0.00% | 0.00% | 0.00% |
| Tax-Cost S&P 500 ETF Exposure⁴ | -0.16% | -0.16% | -0.16% |
| After-Tax Return | 2.55% | 5.09% | 0.00% |
Data below was obtained on 7/16/24 at 2:20 PM ET.
| Option (7/17/25 Maturity) | Bid | Ask | Midpoint | Estimated Fill⁵ |
| Combo: 200 Strike Call + 9000 Strike Put | $8,331.10 | $8,398.21 | $8,364.66 | $8,381.43 |
| 200 Strike Call | $5,399.10 | $5,432.60 | $5,415.85 | $5,424.23 |
S&P 500 Index Level (SPX): $5,652.16
| S&P 500 Index Level 1 in 1 Year 7/17/25 | Unchanged Price | +10% Price | -10% Price |
| Initial S&P 500 Exposure | $565,216 | $565,216 | $565,216 |
| Percentage in S&P 500 Exposure | 25.5% | 25.5% | 25.5% |
| Remaining Synthetic Fixed Income Exposure | $1,653,493 | $1,653,493 | $1,653,493 |
| Percentage of Synthetic Fixed Income Exposure | 74.5% | 74.5% | 74.5% |
| Profit after 1 Year S&P 500 Exposure(1x 200 Strike Call) | $2,793.50 | $59,315.10 | $(53,728.10) |
| Profit after 1 Year Synthetic Fixed Income (2x 200 Strike Call and 2x 9000 Strike Put) | $83,713.50 | $83,713.50 | $83,713.50 |
| Total Profit After 1 Year | $86,507.00 | $143,028.60 | $29,985.40 |
| After-Tax Return (Same as Pre-Tax) | 3.90% | 6.45% | 1.35% |
| Scenario | S&P 500 Unchanged Price (Pre-Tax / After-Tax) | S&P 500 +10% Price (Pre-Tax / After-Tax) | S&P 500 -10% Price (Pre-Tax / After-Tax) |
| Treasuries + S&P 500 ETF | 3.96% / 2.31% | 6.51% / 4.86% | 1.41% / -0.24% |
| Muni NY ETF + S&P 500 ETF | 2.71% / 2.55% | 5.25% / 5.09% | 0.16% / 0.00% |
| Options Replication | 3.90% / 3.90% | 6.45% / 6.45% | 1.35% / 1.35% |
As you can see from the chart above, the pre-tax returns of the balanced portfolio with Treasuries and an S&P 500 ETF position are quite similar to those of the options replication portfolio. However, the tax savings are meaningful when sufficient tax losses are available to offset the capital gain generated from the options positions.
The tax treatment of alternative investments is relatively complex and will depend on the strategy and the investment vehicle.
For example, a Registered Investment Company (“RIC”) such as a mutual fund or ETF, typically deducts fund expenses against the income the fund generates. Hedge funds structured as a limited partnership or LLC typically will pass through income and expenses separately on a K-1 to shareholders. While a performance allocation (such as the traditional 20% performance) is still effectively deductible, many expenses (including management and administrative fees) are not under current tax law.
The following examples demonstrate the tax impact, assuming a 10% return to the investor (net of 3% expenses that cannot be deducted for tax purposes) for an NYC-based investor with $1M of other income:
Given the tax impacts illustrated in the prior examples, it can be quite appealing to utilize a Traditional or Roth IRA to make these investments, particularly those that generate ordinary income, such as private credit funds. That said, there is another type of tax on retirement vehicles, known as Unrelated Business Income Tax (“UBIT), which can be triggered when investing through passthrough entities such as an LLC or LP that borrow funds to invest or operate businesses. This is a complex topic beyond the scope of this article.
As detailed above, optimizing a portfolio for tax considerations can involve some complexity, but the impact can be meaningful. In addition to the abovementioned strategies, tax loss harvesting and direct indexing strategies can help generate tax losses, improve after-tax outcomes, and complement the strategy mentioned. While this primer is a good starting point for understanding optimizing portfolio tax efficiency, several other investment tax characteristics are beyond this article’s scope, including but not limited to real estate and oil and gas investments.
¹A NYC taxpayer with $1M of taxable income will have the following marginal tax rates
²For the DFA ETFs listed with a history of less than five years, we utilized mutual fund tax data but removed the tax impact of any mutual fund capital gain distributions. This adjustment was made to operate under the assumption that the ETF in-kind creation and redemption feature of ETFs facilitated by authorized participants would prevent capital gains distributions.
³Tax-Cost of Treasury Position: 4.9% yield * 74.5% weight * 40.8% tax rate (highest Federal marginal tax rate): 1.49%
⁴Calculated utilizing the average tax cost over the past five years for a NYC-based taxpayer with $1,000,000 of income prior to the investment income.
⁵Halfway point between the midpoint and ask on options quote shown.