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Fixed income needn’t be so taxing

We believe tax management of fixed income should be at the fore of investors’ minds, given the heavy tax drag often imposed by these holdings. Three Wellington thought leaders tackle this vexing issue and offer potential solutions.

This paper is intended to encourage discussion of tax points and should not be construed or relied upon as tax advice. Tax planning is highly fact-dependent and should be undertaken with the assistance of a qualified tax advisor.

The views expressed are those of the authors at the time of writing. Individual teams may hold different views. The value of your investment may become worth more or less than at the time of original investment. Please refer to the risks section near the end of the PDF available below.

Key points

  • Across portfolios, we believe the most challenging investment tax issues can often be found in an investor’s fixed income allocation.
  • Over time, the right portfolio implementation choices may materially enhance after-tax returns on fixed income investments.
  • Tax-exempt municipal bonds and other tax-advantaged bonds remain a cornerstone of many taxable investors’ fixed income allocation.
  • However, for taxable investors who wish to allocate beyond municipals, most asset managers have yet to solve the fixed income tax challenge.
  • We believe fixed income investors can reduce tax burdens by focusing on sector and security selection and capital gain/loss management, among other strategies.

A DECADE OF STRONG MARKET RETURNS combined with recent tax reform has heightened interest in the impact of taxes on investment returns. Taxes are no different from management fees — albeit one essentially levied by governments on investment gains and income. It has been our experience that portfolio implementation choices can materially change the total amount of taxable investment gains and income, as well as the rate at which taxes are paid, in a given year and over the lifetime of an investment. This, in turn, may meaningfully increase or decrease the net returns taxable clients earn on an after-tax basis through time.

Across portfolios, we believe the most challenging investment tax issues can often be found in an investor’s fixed income allocation. Unlike in equity markets, fixed income “buy-and-hold” strategies are generally inefficient from a tax perspective. Indeed, simply holding a bond to maturity typically generates interest or other yield income that may be subject to a 40.8% maximum tax rate on the federal level (and potentially additional state and local taxes). In addition, many actively managed fixed income strategies generate significant short-term gains that are also taxed at the top federal marginal tax rate.

Taking all of this into account, it is not difficult to see how swiftly and deeply taxes can cut into investment returns, especially over a period of years…

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