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Strategy
Strategies to Minimize Taxes: Tax-Managed Index Funds
By Tim Bock
President, Summit Portfolio Management
The most advanced products for tax-efficiency are tax-managed index funds (TMIFs). To keep taxes low, there are five primary techniques that TMIFs apply: low turnover, expanded securities trading range, dividend management, tax loss harvesting and avoidance of short term capital gain realization.
Within a TMIF, realized taxable gain from stock turnover will be negligible due to low turnover, matching losses with gains, and "expanded trading range."
The "expanded trading range" is a set of trading rules that the index fund manager will place on stocks before selling. For example, a small company grows too big to be considered small (for a small company index fund). A TMIF will allow a wider range of price change before selling, thereby postponing or even eliminating a taxable capital gain.
Reducing taxable dividends is desirable as long as the portfolio’s expected return remains the same. All other things being equal, if two portfolios have the same expected return, the one with a lower dividend will produce a higher after-tax return, with a relatively higher portion of the return coming from deferred capital gain.
Dividend management is accomplished in several ways: For example, portfolios are constructed by reducing the percentage of high dividend-paying stocks and increasing low dividend-paying stocks - without sacrificing the financial characteristics of company size or price/book and without changing the expected return of the portfolio. Another technique to minimize dividend income is to postpone the purchase of new securities just prior to the record date of the dividend (for stocks intended to be purchased) or accelerate the sale of a stock just prior to the record date (for stocks that are intended to be sold). This way the total return is not altered, but the taxable dividend has been avoided.
Tax loss harvesting is a technique to further minimize tax. A stock with a loss is sold and replaced with a stock of similar market cap and price/book. The objective with tax loss harvesting is to reduce capital gain liability without changing the financial characteristics of the portfolio. Passive tax-managed funds are currently available for the following asset classes:
US Core Equity (value and small companies tilt)
US Megacap
US Large Cap Value
US Small Cap Value
US Small Cap
US Microcap
International Large Cap
International Core Equity (value and small companies tilt)
International Large Cap Value
Emerging Markets Core (value and small companies tilt)
Emerging Markets Large Cap
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