How to Measure Tax Efficiency

What is Tax Efficiency?

Tax‑efficient investing seeks to maximize after‑tax returns by minimizing tax liabilities. It requires solving two problems simultaneously: maximizing risk‑adjusted return while minimizing the expected tax liability.

The interplay between returns and taxes and the myriad investment options can make tax‑efficient investing challenging. Advisors must consider and select the optimal account structure, asset allocation, asset location, investment product, portfolio management process, and reporting tools.

Clients have always been highly aware of taxes. They understand the drag taxes place on returns. The simple math of investing for retail clients is essentially pretax money + gains and income − taxes owed = after‑tax money. How good is your investment firm at turning pre‑tax dollars into spendable after‑tax dollars?

Why is Tax Efficiency Often a Second Thought for Most Firms?

Yes, most advisors consider taxes in their processes, but how many measure after‑tax returns and systematically seek to reduce taxes owed by their clients?

An obvious answer is that measuring after‑tax returns is hard. Tracking individual tax lots, estimating the tax owed on distributions and dividends where taxes are paid at a date different from the pay‑date and from a checking account instead of the investment account, accounting for earned income and non‑financial assets, and considering a range of other client factors is a serious undertaking. To further compound the challenges, the impact of deferred tax liabilities will be felt far in the future, driven by individual client and market factors that are difficult to predict. The best we can do is measure a hypothetical, estimated after‑tax return for our clients.

Another related explanation is that technology, marketing, reporting, incentives, and data are focused on pre‑tax returns. Many investors, and the largest by assets (namely endowments, foundations, and pension plans), don't pay taxes on their investment gains. This large pool of non‑taxable assets and their managers influences what types of products are available, how those products are managed, and what information is readily available for those products. Unfortunately for retail investors, endowments, foundations, and pension plans don't care about after‑tax returns.

How significant is the non‑taxable influence? Institutions are estimated to represent 90 percent of trading volume on the New York Stock Exchange¹. The rise of the non‑taxable investor also coincides with dramatic innovations in investment management theory and technology. In 1950, 15% of all common stock outstanding was owned by institutions. In 1980, their share had grown to 40%; by the early 1990s, they owned 50% of the outstanding shares². In 2017, Pensions & Investments estimated that institutions held 80% of the market value of the Russell 3000 index³. This percentage is even more impressive when you consider the increase in market capitalization since 1950.

This rise of pension funds coincided with the transformation of the stock market and the genesis of analytical tools to build portfolios. Innovation often flows from large, sophisticated institutions to retail investors, but these two investor types have fundamental differences.

Despite these headwinds, client‑first advisors appear to be taking a stand. They seek to prioritize after‑tax returns, measure their effectiveness, and push their partners to offer more tax‑consideration resources for wealth planning.

Why Now?

According to the 2023 T3 Advisor survey, tax‑planning software went from being used by 29% of advisors in 2022 to 43% in 2023.⁴ In addition, ETFs and tax‑managed SMAs (e.g., direct indexing) continue to grow – fast.

Improved tax capabilities can be seen as a differentiator in an increasingly competitive market. Advisors who quantify the savings from tax‑optimal implementation can often better differentiate their practice, win clients, and demonstrate value beyond selecting products and determining asset allocation.

Tax Rates and Tax Alpha

Taxes are generally due on clients' investment returns, usually a combination of capital gains, dividends, and income. The tax owed is a function of the amount taxed and the tax rate applied. This is where managing clients' tax bills starts to get complicated. Capital gains, dividends, and income have different tax rates, timing, and rules. We use the term taxable event to denote an action that generates a tax bill.

Capital Gains

Capital gains are taxed when they're realized, meaning at the time the asset is sold. Capital gains are also classified as short‑term or long‑term depending on how long the asset has been held. In 2025, the U.S. government taxes long‑term capital gains at a maximum of 20% and short‑term capital gains at 37%. Each year, clients pay taxes on the net realized capital gains (i.e., losses can offset gains).

Interest Income

Bond and money‑market funds generally pay interest that is taxable to the client when received. Interest payments are considered income and taxed at a maximum federal rate of 37%.

Dividends

Dividends are taxable to a client when received. Dividends can be classified as qualified or non‑qualified depending on the holding period of the underlying stock. Qualified dividends are taxed at the long‑term capital‑gains rate (20%), while non‑qualified dividends are taxed as ordinary income (37%).

3 Methods for Optimizing Tax Efficiency

Organizing the taxability of returns (e.g., income, capital gains, dividends) helps demonstrate why ETFs and tax management are valuable for clients. While market returns and manager alpha are outside our control, the characterization, timing, and size of taxable events are in our control (to some extent). With thoughtful planning and the right products, advisors can help reduce tax bills and potentially add meaningful value for their clients . Let's look at three methods of increasing tax efficiency.

1. Decrease the average tax rate.

As highlighted above, taxable events aren't created equal. Long‑term capital gains (LTCG) and qualified dividends are taxed more favorably than short‑term capital gains (STCG), interest, and ordinary dividends. Advisors that decrease the average tax rate across the portfolio can meaningfully improve after‑tax returns.

Source: Federal income-tax rates and brackets | Internal Revenue Service and 2024 Publication 550

In taxable accounts, advisors should prioritize assets taxed as long‑term capital gains (e.g., individual equities, equity ETFs, etc.) because of the lower tax rate and option to defer the tax bill indefinitely (more on deferral below). Qualified dividends are also taxed at a lower rate, but tax is due in the year the dividends were received, meaning there is no option to defer the tax bill.

2. Decrease the taxable amount.

Advisors can also improve their portfolios' tax efficiency by reducing the amount of income, dividends, or realized capital gains that are taxed. The most common method of reducing taxable events is employing intelligent asset‑location strategies. Assets in tax‑advantaged accounts can defer or eliminate taxes on dividends, capital gains, or income. By holding tax‑inefficient assets like taxable bonds, alternatives, or high‑turnover active strategies in tax‑advantaged accounts, advisors can reduce the number of taxable events and, therefore, the amount taxed.

While most advisors are considering asset‑location strategies, more enterprising investment teams are often also implementing strategies to reduce taxes on capital gains by strategically realizing capital losses. Clients pay tax on realized capital gains net of any capital losses. Any realized capital losses in clients' portfolios can directly reduce taxes owed on other capital gains. Ideal use cases for systematic tax‑loss harvesting include:

• Recent sale of primary residence
• Diversifying from concentrated positions
• Offset capital gains from other investments (e.g., alternatives)

Lastly, advisors can build flexibility into their investment process to avoid selling legacy positions. Advisors who avoid selling appreciated positions allow the position to continue compounding at the pre‑tax value, taking advantage of the magic of gains deferral.

3. Defer taxes.

Deferring taxes may feel like a subtle strategy, but it taps into one of the strongest forces in investing: compounding. Evaluating the value of deferred taxes is critical because advisors must often choose between changing a client's portfolio (incur taxes today) or staying the course (defer the taxes).

Let's look at a hypothetical example.

A client has a taxable brokerage account worth $3 million holding shares of a U.S. large‑cap value ETF. The cost basis of the shares is $1 million. The client's new advisor, who doesn't have an allocation to value in their model, is considering selling the position to fund a U.S. large‑cap blend ETF. The client, a New York resident, expects to pay 30.9% in long‑term capital gains (20% federal + 10.9% state).

Comparing the liquidation value (i.e., the portfolio's value after selling all shares and paying taxes) demonstrates the power of tax deferral and compounding. On day one, the value of the two portfolios is the same—that is, the value of the retained large‑cap value portfolio if it were sold to cash, compared to the newly purchased large‑cap blend portfolio if it were also liquidated, is the same.

However, from there, the values begin to diverge. The large‑cap value portfolio compounds from a base of $3 million. Its tax liability is deferred until the day the shares are sold. On the other hand, the large‑cap blend portfolio has already incurred a tax bill and only grows from a starting point of $2.382 million. Assuming 7% annualized growth for both portfolios, the value of avoiding the tax bill in 10 years is over $400,000. Over 30 years, the value is $2.8 million—more than the liquidation value of the portfolio today.⁵

​

Today

10 years

30 years

Hold

$2,382,000

$4,386,905

$16,089,205

Replace

$2,382,000

$3,973,894

$13,265,521

Value of Tax-Deferred Growth

$0

$413,010

$2,823,684

For illustrative purposes only.

In addition to increasing compounding, deferred taxes have another, more subtle benefit. The deferred‑tax liability—the taxes owed when an appreciated asset is sold—creates risk‑sharing between the investor and the government. From Stuart Lucas' “The Taxable Investor's Manifesto:”

Author's note: The below example refers to an asset with a market value of $10 and a cost basis of $2.

“When the values of appreciated securities fall, the government suffers a disproportionate percentage of the decline. In this example, if your $10 stock falls 50% in value, the deferred tax liability drops 63% while your owner's net worth drops 47%.”⁶

How to Measure Tax Efficiency

To ensure their efforts guide decision‑making, offer return on investment, and communicate value to clients, advisors must be able to measure the tax efficiency of their portfolios and the products they select.

Below we lay out three tools and one comprehensive framework that advisors can use to guide their decisions and measure the effectiveness of their investment process.

1. Morningstar's Tax Cost Ratio

Morningstar’s tax cost ratio “measures how much a fund’s annualized return is reduced by the taxes investors pay on distributions.” It’s a ratio of the annualized after‑tax return compared to the annualized pre‑tax return. It’s important to note that the tax cost ratio doesn’t consider the eventual tax an investor pays when liquidating (i.e., it’s based on pre‑liquidation returns).⁵

Formula:
T_i = 1 − (1 + ATR_i) ⁄ (1 + L_i)

The tax cost ratio is expressed as a percentage and is similar to an expense ratio. The ratio usually falls between 0‑5%, with 0% being the most tax efficient (i.e., no taxable distributions).⁵

Pros:

• Simple, easy-to-find, and easy-to-compare tax efficiency measure
• Helps advisors identify the tax impact of fund distributions and their tax character
• Compared to simply reviewing after-tax returns, the tax cost ratio isolates the effect of taxes

Cons:

• Tax cost ratio depends on pre-liquidation after-tax return, which doesn’t consider the eventual tax an investor pays when closing the fund position
• Ignores state and local taxes
• Doesn’t include Net Investment Income Tax

2. Liquidation Value

The liquidation value of a portfolio or fund is the hypothetical value if the portfolio were liquidated to cash and all applicable taxes were paid.

Pros:

• Captures the impact of deferred capital gains and (if appropriately tracked) taxes on distributions throughout a portfolio's life
• Offers a comprehensive picture of tax efficiency

Cons:

• Tracking the appropriate data over time, including dividends, distributions, and income, can be difficult
• The time lag on changes in liquidation value (i.e., two portfolios invested with the same balance have identical liquidation values on day one) requires assumptions on the level and characterization of returns
• Liquidation values can be challenging to calculate for assets held in complex account types (e.g., certain trusts)

3. Tax Alpha

Tax alpha is the return of a tax‑managed portfolio minus the return on the same portfolio without tax management. It measures the additional value generated from tax‑loss harvesting, gains management, and tax‑aware transitions (if applicable). Tax alpha is often measured in two flavors: pre‑liquidation and post‑liquidation.

Pre‑liquidation tax alpha is most applicable for portfolios expected to be gifted through an estate. It assumes that taxes are paid on dividends, income, and realized capital gains throughout the portfolio's life; however, taxes on deferred capital gains are avoided as the portfolio benefits from a step‑up in cost basis.

Post‑liquidation tax alpha assumes that the portfolio is sold to cash, and deferred‑capital‑gains taxes are fully paid at the end of the measurement period. This measure applies most to portfolios that may be spent during an investor's lifetime.

Tax alpha is a single number that demonstrates the value of tax management on a single strategy or model portfolio. Advisors should know that embedded assumptions and time horizon drive tax‑alpha estimates. In particular, the assumptions for the amount and characterization of the client's external capital gains and marginal tax rate will impact the level of estimated tax alpha.

Pros:

• Easy to explain to clients because it is shown as an annualized return alongside pre-tax and post-tax returns
• Demonstrates the value of tax management in both backtests and live portfolios

Cons:

• The calculation of tax alpha relies heavily on assumptions, including external capital gains, tax rates, and the reinvestment of tax refunds
• Tracking taxable events, including dividends, income, and realized capital gains, and appropriately applying those events to the portfolio and non-tax-managed benchmark portfolio, can be challenging

4. Hypothetical After‑Tax Returns

Advisors looking for a comprehensive view of tax efficiency can calculate and aggregate hypothetical expected after‑tax returns for each part of their portfolio. Calculating after‑tax returns requires estimating an effective hypothetical tax rate for each product or asset class. This process is part science and part art. The advisor must determine the implied tax rate based on realized return, tax rate, expected holding period, and asset location for each product or asset class in a client's portfolio. For example, an index‑equity ETF held in a taxable brokerage account could be broken down as follows:

• 2% expected dividend yield taxed at qualified-dividend rates
• 100% of price return taxed at long-term capital-gains rates when liquidated

By contrast, an actively managed equity strategy held in a taxable brokerage account could be broken down as follows:

• 2% expected dividend yield taxed at qualified-dividend rates
• 23% of price return taxed at short-term capital-gains rates per year
• 47% of price return taxed at long-term capital-gains rates per year
• 30% of price return taxed at long-term capital-gains rates when liquidated

Evaluating each product or asset class could lead to an after‑tax analysis that looks something like this:

Returns and estimated tax rates are for illustrative purposes only and do not represent an actual investment.

Building Tax‑Efficient Portfolios is an Ongoing Process

There isn't a one‑size‑fits‑all approach to building tax‑efficient portfolios. The first step is being aware of the impact of taxes on client portfolios and internalizing the drivers of after‑tax return. From there, advisors can identify products and strategies that have the potential to deliver the best outcomes for their clients.

As your firm matures or invests in its after‑tax capabilities, there are two significant steps to take. First, estimating after‑tax returns for clients can help refine portfolio construction and ongoing management. Second, investing in in‑house or outsourced technology that can turn tax‑lot and taxable events (e.g., dividends, distributions) into actionable insight can further differentiate your firm.

Sources:

• 1. Retail traders account for 10% of U.S. stock-trading volume in 2021 – Morgan Stanley: https://www.reuters.com/business/retail-traders-account-10-us-stock-trading-volume-morgan-stanley-2021-06-30/
• 2. Bernstein, Peter L. Capital Ideas: The Improbable Origins of Modern Wall Street. New York: John Wiley & Sons, 2005.
• 3. Pensions & Investments 80% of equity-market cap held by institutions: https://www.pionline.com/article/20170425/INTERACTIVE/170429926/80-of-equity-market-cap-held-by-institutions
• 4. T3: Rapid Uptick in Tax and Estate-Planning Software by Advisors: https://www.wealthmanagement.com/estate-planning/t3-rapid-uptick-in-tax-and-estate-planning-software-by-advisors
• 5. Fidelity Capital-Gains Tax Deferral Calculator Standalone: https://institutional.fidelity.com/advisors/tools-and-resources/tools-and-calculators/capital-gains-tax-deferral-calculator-standalone
• 6. Lucas, Stuart E. The Taxable Investor's Manifesto: Wealth Management Strategies to Last a Lifetime. John Wiley & Sons, Inc., 2020.

Important Information

This material is intended solely for educational purposes and should not be construed as investment advice, a recommendation, or an offer or solicitation to purchase or sell any securities. The opinions expressed are as of the date(s) indicated and are subject to change without notice. Reliance upon the information herein is at the sole discretion of the reader.

Investing involves risk; principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. Shares are bought and sold at market price, not net asset value (NAV). Market‑price returns are based upon the closing composite market price and do not represent the returns you would receive if you traded shares at other times.

This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. Harbor Capital and its associates do not provide legal or tax advice.

Any tax‑related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material.

ETFs are subject to capital‑gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are generally minimized for the holder of the ETF. An ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying portfolio. However, capital‑gains tax may be incurred by the investor after the ETF is sold.

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