Tax Strategies

Taxes can have a surprisingly negative impact on long-term portfolio returns, and the consequences of paying taxes on top of manager underperformance can be especially painful. In today’s challenging, potentially low-return environment, return lost to taxes could mean the difference between positive and negative investment performance.

Fortunately, investors have innovative tools to implement short- and long-term tax strategies: iShares ETFs.

Short-Term—Harvest Losses & Gains

Investors can employ tax-loss harvesting strategies at year-end to reduce overall tax liability. By selling a position at a loss—whether an individual security, open-ended mutual fund or an ETF—an investor can offset gains in the same portfolio and, in turn, reduce or eliminate tax liabilities. By purchasing an ETF that is highly correlated to the sold security, an investor can help reduce cash drag* on the portfolio and/or an inadvertent underweight to a particular sector by getting invested again immediately.

*Cash drag can occur when an investor allocates a portion of his portfolio to cash, thereby missing out on possible performance gains for that portion of the portfolio.

iShares ETFs Tax Strategy: Loss Harvesting

In December 2010, Congress agreed to a temporary two year extension of the Bush-era tax cuts. Unless new legislation is passed, tax rates are likely to go up for most tax brackets after the extension expires. If tax rates are on the rise, an investor could implement a tax gain harvesting strategy. This would involve realizing gains now, prior to a shift to higher tax rates, and would potentially reduce tax liabilities in the future.

Long-Term—Investment Selection

When it comes to tax efficiency, not all investments are created equal. By creating a tax-efficient core—replacing tax inefficient investments with tax-efficient iShares ETFs—investors may avoid costly tax implications.

iShares ETFs can achieve tax efficiency in several ways:

Lower portfolio turnover associated with index funds translates to potentially lower capital gain distributions.
An exchange traded structure insulates investors from the effects of other shareholder transactions.
iShares’ experienced portfolio management team works to keep capital gains distributions to a minimum.

Long-Term—Rebalancing

Traditionally, rebalancing involves selling the "winners" and buying the "losers"—a strategy that may entail incurring capital gains on recently-sold "winners."

Instead of buying more of the loser, however, a tax-aware investor might sell the loser (using a tax loss harvesting strategy) to offset the gain of the winner, and in turn replace the security with a highly correlated iShares ETF. By virtue of this process, an investor can rebalance his asset allocation weights while also seeking to improve the long-term after-tax performance of the portfolio.

Long-Term—Asset Location

Asset location is becoming an increasingly important part of a tax-aware investment process. By distributing investments effectively across taxable and tax-advantaged accounts, an investor can work to minimize tax cost.