Home Adviser Fund Update Tax-Efficient Investing Published March 28, 2014 Tax-Efficient Investing You’ve likely had to account for dividendsA cash payment to investors who own stock in the company. and capital gains this year or in the past as you filed your taxes, perhaps begrudging the extra work entailed and the levies due. While taxes are one of life’s certainties, with some preparation and planning, there are ways you can make your portfolio more tax efficient, putting off or reducing your annual tax burden. The concept of tax efficiency considers how various assets generate returns and the tax rates on those returns. Different investments are taxed at different rates; once you have decided on the appropriate asset allocation for your objectives and riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. comfort zone, the next step is to think about fitting it into a tax-efficient framework. At Adviser Investments, we always try to be cognizant of how taxes can impact total return. Every client’s situation is different, so there are no universal rules, and in general, overall portfolio performance is more important than avoiding some taxes (especially if it means investing in lower-return funds to do it). That said, there is some consensus thinking on the subject that any investor can consider. Taxable, Tax-Deferred and Tax-Exempt Investment accounts generally fall into one of three classifications of the tax code: Tax-free accounts, tax-deferred accounts and taxable accounts. Investors with tax-free accounts, including Roth IRAs, Roth 401(k)s and 529 college savings plans, owe no tax on current income or capital gains on profits, since contributions are generally made after taxes. In tax-deferred accounts like traditional IRAs and 401(k)s, investors don’t owe income tax until they begin making withdrawals, typically in retirement. The tax-deferred structure allows investments to compound untaxed, greatly enhancing long-term growth potential. Taxable accounts encompass all other investment accounts. While it’s ideal to max out annual contributions to your tax-exempt and tax-deferred accounts if possible, if you need current income from your investments or don’t want them locked up until you reach retirement age, you’ll need to keep some portion of your assets in a taxable account. And taxable accounts offer certain advantages over tax-advantaged accounts, where all investments are taxed equally. In taxable accounts, you can harvest losses to deduct from your taxes, donate shares to charity and pay lower taxes on capital gains realized over periods longer than a year. StocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and StockA financial instrument giving the holder a proportion of the ownership and earnings of a company. Funds Every time an asset is sold in a taxable account, gains must be accounted for—and losses should be logged as well for tax deduction purposes. The longer gains are held, the longer you put off paying taxes on them, so choosing long-term investments wisely can really pay off. You also need to be aware that when mutual funds and ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. make trades with their portfolios, the taxes generated from the turnover are paid by clients. According to Morningstar, actively managed equityThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid. funds have a median turnover of 49%, creating both short- and long-term taxable gains. Index funds are not immune from these taxes, either, especially narrowly focused indexes. For example, when a holding in a mid-cap index gets too big or small, it must be sold. While index funds tracking the S&P 500 or other broad market indexes are the most tax-efficient, they too must sell holdings to take positions in new additions to the index. Stock funds can also be tax-inefficient if they produce a lot of capital gains, especially short-term capital gains. Funds that pay dividends can also see their returns impacted by taxes. Tax Efficiency of BondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. Bonds and bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. funds are sometimes considered to be tax inefficient because much of their return is generated by monthly distributions, which is taxed as ordinary income and thus faces the maximum tax rate. This is especially true when compared to stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company., where, in general, returns primarily come from price appreciation and are only taxed when sold at a profit at the capital-gains tax rate. (See current rates in table below.) Treasury bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. are exempt from state taxes, while municipal bonds are tax-free on the federal level (and sometimes state level, depending on the issuer). However, municipal bonds have a hidden cost in that they typically yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. less than comparable corporate or Treasury bonds. Of course, muni bonds do have the built-in tax advantage, and during certain periods or market conditions, their yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. can become more attractive compared to or even higher than taxable bonds of similar duration (this is currently the case). Asset Placement A general rule when considering the tax consequences for a portfolio is that taxable accounts should house tax-efficient investments, and tax-inefficient vehicles may work better in tax-deferred accounts. The table below shows how different assets could be placed in a tax-efficient framework. Taxable Accounts Tax-Deferred Accounts Broad Stock Index Funds Taxable Bonds and BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. Funds Low-Turnover Stock Funds High-Turnover Stock Funds Tax-Managed Funds CDs Individual Stocks REITs Why hold stocks in taxable accounts? For one, capital gains can be deferred indefinitely—so long as you don’t sell any shares—and qualified dividends are taxed at 15% (20% for the highest income-tax bracket), much lower than ordinary income regardless of your tax bracket. (To a certain extent this is also true of stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. funds, but as mentioned above, the tax efficiency can be impacted by portfolio turnover and short-term capital gains. That said, we think most investors are still better served by mutual funds’ diversificationA strategy for managing investment risk by investing in a mixture of different investments. Since different asset classes face different risks, even if one type of asset declines in value, others may not. than they are by a single company’s stock’s potential tax efficiency.) Stocks and stock funds in tax-deferred accounts see long-term gains turned into income, meaning gains are taxed at a higher rate. Federal Income Tax Rates for 2013 and 2014 Taxable Income Tax Rate Single Married/Joint Head of Household Ordinary Income & Short-Term Capital Gains Long-Term Capital Gains and Qualified DividendsA cash payment to investors who own stock in the company. 2 0 1 3 $36,251 to $87,850 $72,501 to $146,400 $48,601 to $125,450 25% 15% $87,851 to $183,250 $146,401 to $223,050 $125,451 to $203,150 28% 15% $183,251 to $398,350 $223,051 to $398,350 $203,151 to $398,350 33% 15% $398,351 to $400,000 $398,351 to $450,000 $398,351 to $425,000 35% 15% >$400,000 >$450,000 >$425,000 39.6% 20% 2 0 1 4 $36,901 to $89,350 $73,801 to $148,850 $49,401 to $127,550 25% 15% $89,351 to $186,350 $148,851 to $226,850 $127,551 to $206,600 28% 15% $186,351 to $405,100 $226,851 to $405,100 $206,601 to $405,100 33% 15% $405,101 to $406,750 $405,101 to $457,600 $405,101 to $432,200 35% 15% >$406,750 >$457,600 >$432,200 39.6% 20% Note: Table does not include additional 3.8% Medicare tax rate on investment income in excess of adjusted gross income of $200,000 ($250,000 for married filing jointly) and 0.9% on salary and self-employment income exceeding this amount. Also excludes 10% and 15% tax brackets, which are not subject to long-term capital gains taxes. Consider all of your assets and their tax consequences. Generally speaking, investments that tend to lose less of their return should go in taxable accounts, while those generating lots of taxable distributions not needed for current income, or where you’re frequently trading (for example, by following an annual rebalancing scheme) would cause fewer tax headaches in a tax-deferred or tax-free investment account. But as we wrote above, every investor is different, and what makes sense for your neighbor might not make sense for you. If you have any questions or concerns about the tax efficiency of your portfolio, we recommend that you confer with a trusted tax or investment professional before making any moves. The discussion should be able to help you confirm that you’re making the right choices or reveal other means of achieving the same goal. One thing we tell our clients when they begin to focus more on avoiding taxes than the shape of their overall portfolio is, “Don’t let the tax tail wag the portfolio dog.” In other words, tax efficiency is not nearly as important as achieving solid after-tax returns. Next Time In our next Adviser Fund Update, we’ll look at the tax efficiency and tax-adjusted returns of Fidelity and Vanguard funds, which will help us show you how the tax efficiency of a fund is not always the best way to gauge the quality of the investment. About Adviser Investments Adviser Investments operates as an independent, professional wealth management firm with expertise in Fidelity and Vanguard funds, actively managed mutual funds, ETFs, fixed-income investing, tactical strategies and financial planning. Our investment professionals focus on helping individual investors, trustsA legal document that functions as an instruction manual to how you want your money managed and spent in your later years as well as how your assets should be distributed after your death. Assets placed in a trust are generally safe from creditors and can be sold by the trustee in short order, avoiding the lengthy and costly probate process., foundations and institutions meet their investment goals. Our minimum account size is $350,000. For the fifth consecutive year, Adviser Investments was named to Barron’s list of the top 100 independent financial advisers nationwide and its list of the top advisory firms in Massachusetts in 2017. We have also been recognized on the Financial Times 300 Top Registered Investment Advisers list in 2014, 2015 and 2016. For more information, please visit www.adviserinvestments.com or call 800-492-6868. Disclaimer: This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged. Past performance is not an indication of future returns. The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. We do not provide legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. The Barron’s rankings consider factors such as assets under management, revenue produced for the firm, regulatory record, quality of practice and philanthropic work. This award does not consider client experience and is not indicative of future performance. Editors at the Financial Times bestowed “elite” status on 300 firms in the U.S., as determined by assets under management, asset growth, longevity, compliance record, industry certifications and online accessibility. © 2018 Adviser Investments, LLC. All Rights Reserved.