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Impact Transformation: Part III - Managing the Costs

| January 29, 2020
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Good for you. You've decided you want an investment portfolio that reflects your values as well as your financials goals. But you're worried about the costs of a Big Transition.

"What about all of the gains?" you ask.

Assuming the we're not working through a tax-deferred account, yes, we all pay some taxes. But, with care, they can be managed.  And you surely won't have to take "all of the gains."  Here are some thoughts on how to manage this transition, and how to get to your desired allocation.  The key is to use great care in the timing and specific actions taken.  With a plan and a budget, this transition need not be scary.

Tax Lots Matter

Thanks to a strong bull market for the past decade, most portfolios contain a lot of gains.  But not every tax lot has such a large profit.  Reviewing the specific tax lots can identify those ones that can be sold with the least tax hit. Dividend reinvestment plans may have even made purchases at prices above the current levels, meaning that losses can be hidden amidst gains.  Taking care to examine each tax lot can be well worth the effort.

Mutual Funds are Always Not Under Your Control

If you hold traditional mutual funds, your embedded profits might be distributed to you sooner than you expect.  Unlike stocks and ETFs, the manager of the fund controls when gains are realized.  Investors, therefore, can't view these gains as "locked up".  Managers often have to sell positions due to investor outflows when market performance is weak.  So, funds are rightly considered to be candidates for re-positioning.  

Lower Volatility Assets Likely Have Less Tax Liability

US stocks have been among the best performing assets in the past ten years, but other asset classes have done less well in comparison.  As such, they may be ripe for a transition to the new model. Foreign stocks, listed alternatives and even fixed income could be candidates. Some of these "diversifiers" could be re-allocated to impact investments in the private markets, thereby continuing to add diversification and low volatility characteristics. 

Much of Your Portfolio can be Retained

When transitioning to a high-impact model, a good advisor will segregate high ESG-scoring companies from the poorer ones, retaining the ESG leaders as part of the new portfolio.  Sure, those positions might be a bit larger than manager would recommend (all things equal), but this customized approach will pay off in lower realized capital gains taxes.  Companies such as Microsoft, Starbucks, and Walt Disney are among the top holding of sustainable funds and could be retained in a new impact-focused portfolio.

Capital Gains Tax Rates are Indexed to Reported Income

Chances are, your capital gains tax rate is less than you think. Recent tax law changes mean that if you report less than $40,000 in income, your long term capital gains tax rate is ZERO. And if you report less than about $500,000, as a couple, your long-term Federal capital gains tax rate is 15%. Working to defer income, and generate more tax-exempt income, can thereby bring down your capital gains tax rate, too. 

Average it Out, and Think Long-Term

By spreading your portfolio's transition over three to five years, and by making sure that your holdings are held for more than a year, the annual tax bill for such a transition can be rather modest -- Just a few percent of the portfolio's value per year. Inevitably, weaker markets will occur, creating short term opportunities to further offset some of the gains.

Intra-year Tax Loss Harvesting

While most investors wait until year-end to consider tax loss harvesting, this is an exercise that can be done at any time. Selling securities that have temporary losses creates a currency that can be used to offset capital gains. Firms that focus on tax-managed strategies often make this core to their philosophy. They don't have exclusivity on this technique, however.

Conclusion:  Investors have many ways by which taxes can be deferred or avoided, even when undertaking a substantial portfolio re-positioning.  And in this process, they might even be improving their portfolio's return potential, or reducing portfolio risk, as they incorporate low-volatility impact strategies.  Each client, and each portfolio, is different.  But the transition to an impact investment approach need not be a painful one.

Thinking about making such a change?  We'll map out a plan and show you how to make it all work for you.

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