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A Tax-Efficient Portfolio Makeover May Be Less Painful Than You Think

Proper accounting of cost basis is essential to avoid paying more taxes than you need to.

Editor's note: A version of this article was published on Feb. 19, 2021. It is part of Morningstar's Tax and IRA Guide special report.

It's a fact of life: Many investors begin putting together their portfolios before they really know what they're doing. As they get more knowledge and experience under their belts, they're apt to realize that some adjustments are in order. The young investor who started out with a balanced portfolio may decide he really should be mostly in stocks, for example, or the investor who started out amassing a portfolio of individual stocks may decide that mutual funds are a better fit for her busy lifestyle.

In a similar vein, some investors may have started in a taxable brokerage account without regard for the tax-efficiency of their investments. A few unwanted income or capital gains distributions later, they realize that they should have been more focused on investments that limit those taxable distributions. On the short list of tax-friendly investments for stock investors are individual stocks, broad-market exchange-traded funds and index mutual funds, and tax-managed funds. For bond investors, municipal bonds, whose distributions are free from federal and in some cases state and local taxes, often make sense, especially for people in higher tax brackets.

Trouble is, giving a taxable portfolio a tax-efficient makeover isn't necessarily tax-free. That's because investors pay two sets of taxes: the taxes on income and capital gains distributions they receive during their holding periods as well as taxes on any appreciation they've enjoyed over that same time frame. An investor swapping an investment for a more tax-friendly option may make her portfolio more tax-efficient in the future, but she could incur capital gains taxes to do so. That's a particularly big concern since the stock market has rallied pretty consistently since 2009.

The good news is that if the investor can account for the taxes she has already paid on distributions she received and reinvested during her holding period, she can offset--partially if not entirely--the taxes she'll owe on her own gains. Thus, she may have no reason to put off making her portfolio more tax-friendly in the future.

Reinvested Capital Gains = Prepaying Your Taxes

A simplified example can illustrate how distributions can be costly, from a tax standpoint, in the year in which they're received, but those costs can help offset eventual tax outlays upon selling.

Say, for example, an investor sinks $100,000 into a mutual fund at the beginning of 2017. The fund appreciates by 10% ($10,000) that year and promptly makes a capital gains distribution of 5% ($5,500). Even though the investor reinvests that distribution back into the fund to purchase more shares, she is on the hook for capital gains tax on that amount; let's assume the gains are long-term and she pays a 15% capital gains rate on the $5,500 distribution ($825) for 2018. However, she can also increase her cost basis in the investment to account for the reinvested distribution; in essence, she has prepaid a portion of the taxes due for her fund's appreciation. Her cost basis is now $105,500 and her holdings are worth $110,000. (Her reinvested capital gain is a wash from the standpoint of her account's current value; the fund paid it out and she put it right back in. Had she spent that capital gains distribution rather than reinvested it, her cost basis would remain $100,000 and her holdings would be worth $104,500.)

In 2018, the fund loses 10%. By the end of the year, her fund shares are worth $99,000 (her $110,000 portfolio minus her loss of $11,000). She hasn't made money, but the fund still makes a capital gains distribution--this time 10% of its net asset value, or $9,900 for our hypothetical investor. She again reinvests that distribution and pays 15% in long-term capital gains tax--$1,485--on it. After reinvestment, her cost basis would jump to $115,400 (her previous cost basis of $105,500 plus the reinvested distribution of $9,900).

In 2019, the fund gains 30%, taking her account value up to $128,700. But it also makes another distribution, this time amounting to 8% of NAV ($10,296). After reinvestment, her cost basis is $125,696.

In early 2020, she decides she's fed up with paying taxes on all of those unwanted distributions and wants to switch to a more tax-friendly portfolio mix. The long-term capital gains taxes due upon the sale of her fund would be the difference between her stepped-up cost basis of $125,696 and the value of her shares, $128,700--or 15% of $3,004 ($451). That's not anything to sneeze at, of course, but if it means that her portfolio will be more tax-friendly on a going-forward basis, it may be a sacrifice worth making. She could switch to a broad-market equity ETF, for example.

It's also worth noting that for some investment types, transitioning to a more tax-friendly portfolio will generate few tax implications. Taxable bonds and bond funds, for example, generate most of their returns via income distributions rather than capital appreciation; investors pay taxes on that income in the years in which they receive it. That means selling a taxable-bond fund will typically not bring a big tax hit.

Additionally, it's worth bearing in mind any recent purchases of the holding could be taxed more heavily. That's because securities held for less than a year are dunned at investors' ordinary income tax rates. That may not be a big enough issue to negate the benefits of a tax-efficient makeover, but it's still worth keeping in mind, especially if you add to your holdings gradually via a dollar-cost averaging plan.

The Importance of Good Record-Keeping

The key to receiving the step-upped cost basis is making sure you have good records on reinvested dividends and capital gains distributions. For roughly a decade, investment firms have been required to track customers' cost basis for them. But if investors owned shares prior to those rules going into effect, the onus is on them to keep track of their cost basis and those reinvested capital gains distributions. Otherwise they'll be paying taxes twice--first on the capital gains and dividend distributions they already received, and again when they sold and didn't account for those reinvestments by increasing their cost basis.

The bottom line is that for investors who have been keeping close track of their reinvested dividend and capital gains distributions--or who have only owned their investments since the cost-basis accounting rules went into effect--much of the cost of engineering a tax-efficient portfolio makeover may already be "sunk"; the taxes due upon sale may be less than they imagined. Undertaking a tax-efficient makeover and swapping into more tax-efficient investments may not cost them a lot in capital gains taxes, and, if their holding period is sufficiently long, could pay for itself many times over down the line.

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