A TIPP account is a customized, private investment portfolio designed to mirror the pre-tax performance of the U.S. stock market while providing superior after-tax returns. TIPP stands for "Tax-efficient Indexed Private Portfolio".

Learn more about our proprietary TIPP Accounts by clicking on these links:

  What is a TIPP account?
  The importance of taxes
  The problem with mutual funds
  Advantages of privately managed portfolios

What is a TIPP account?

TIPP stands for "Tax-efficient Indexed Private Portfolio." A TIPP account is a private portfolio designed to track the pre-tax performance of the U.S. stock market while providing superior after-tax returns. TIPP accounts can be benchmarked to the S&P 500 or to a broader stock market index, such as the S&P 1500 or the Wilshire 5000.

There are two major differences between TIPP accounts and other passive investment vehicles:

1. They are individually managed private portfolios, thereby avoiding the problems inherent in commingled portfolios such as index mutual funds
2. They are managed in a tax-efficient manner.

By combining passive stock selection with active tax management, TIPP accounts provide clients with a superior strategy for building wealth with taxable funds.

The importance of taxes

Taxes have a significant, but often overlooked, influence on the performance of taxable investment portfolios. For investors in high tax brackets, capital gains taxes often impact portfolio returns to a greater extent than transaction costs and management fees. Investors are increasingly beginning to realize that after-tax returns are the only returns that matter in a taxable portfolio.

Most of us understand quite clearly that the Internal Revenue Service is our partner in realizing capital gains on investments. The tax hit is particularly painful for equity investments held less than one year. An investor in the top tax bracket will pay federal tax authorities up to 35% of his or her realized short-term gains. This creates a powerful incentive to hold onto appreciating equities for at least one year, at which time they qualify for the long-term capital gains rate of 15%.

Fortunately, capital gains are taxed only when they are realized (ie., when an appreciated stock is sold). This allows you to defer realized capital gains indefinitely simply by holding onto the stock. Furthermore, you can realize capital losses at your discretion and use the losses to offset realized capital gains.

Strategic harvesting of realized losses can be used to minimize or eliminate the tax liability created by realized gains. Careful tax-lot accounting can also be used to sell shares with higher cost bases first (HIFO accounting). These concepts form an integral part of the tax-management strategies employed by Shearwater in managing our TIPP accounts.

The problem with mutual funds

Mutual funds, and other commingled accounts, combine the assets of multiple investors. Although this has definite advantages for small investors, it can create unnecessary tax liabilities for high net worth individuals.

An investor who buys shares in a mutual fund inherits the purchase history of the securities within the portfolio. A particular equity holding often includes shares purchased at different time points and at different prices. Each purchase establishes a cost basis for shares bought on that date. When a mutual fund's average cost basis is lower than its current market value, a new investor inherits the tax liabilities of earlier investors. These liabilities are referred to as embedded capital gains, and they can be quite substantial.

For example, the embedded capital gains in the Vanguard 500 Index Fund amount to about 40% of the fund's total assets. Whenever share redemptions exceed the amount of new money going into the fund, equity shares are liquidated which can result in taxable capital gains for the fund's shareholders. The tax charge is deducted from each investor's account when the fund declares its annual capital gains distribution. When the investor eventually sells his mutual fund shares, he is hit once again with a capital gains tax on the appreciation in share value.

Another disadvantage of commingled accounts is that they complicate tax planning. The individual mutual fund investor does not know his short-term and long-term gains until the end of the year at which time it may be too late to realize offsetting capital losses. Finally, most mutual funds keep some cash in their portfolios for share redemptions and new purchases. Over the long term, this results in a cash drag on portfolio performance.

Advantages of privately managed portfolios

TIPP accounts are private portfolios, which offer an attractive alternative to commingled accounts. TIPP accounts have several important advantages over mutual funds. Many investors have existing securities in their investment portfolios with embedded capital gains. Substantial tax savings can be realized by transferring these assets (instead of selling and then reinvesting) into a private TIPP account. Cost bases and holding periods of each security are then carefully tracked, allowing future realized capital gains to be offset by capital losses.

Another advantage of private accounts is that individuals can deduct net capital losses of up to $3000 per year from ordinary income. Mutual funds, on the other hand, are prohibited from distributing net capital losses to their shareholders. Individual investors can also carry forward net realized capital losses indefinitely, while mutual funds can only carry forward losses for eight years.

Management of TIPP accounts can be tailored to meet your specific needs. For example, capital gains can be postponed until a matching loss is realized from another source. If you have expected future income fluctuations, capital gains realizations can be timed to coincide with a period of lower income and lower marginal tax rates. Careful tracking of unrealized gains can also maximize the tax benefit from charitable donations of equity holdings and assist with tax-efficient estate planning.

Finally, TIPP accounts are customized portfolios that can be designed to address your specific social concerns or preferences. TIPP accounts can also be tailored to avoid exposure to industry groups in which you already have significant holdings or exposure. For example, a pharmaceutical company executive can opt for a portfolio that excludes investments in the pharmaceutical industry.

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