Investing and Taxes
We all know that taxes are one of life’s certainties—one that many people would prefer to avoid. However, singularly focusing on minimizing your tax bill each year could compromise your investment plan and its potential gains. A long-term perspective, preparation and planning to manage your annual tax burden can help you strike a balance between paying less in taxes and improving your portfolio’s returns over time.
Taxes are a cost—reducing the amount of income and capital gains you keep—and as with all costs, keeping taxes low is a sensible practice. But be wary of “letting the tax tail wag the portfolio dog.” By that we mean that investors sometimes take their tax reduction efforts too far and lose sight of the real goal of investing—it’s not about writing the smallest check to Uncle Sam, but maximizing your after-tax dollars. The path to one doesn’t always lead to the other.
For example, consider two funds with similar growth objectives—one is 99% tax-efficient over the last three years (meaning you lose only 1% of your overall return to taxes) and has an after-tax return of 5% a year, while the other is 90% tax-efficient, but returns 7% a year after taxes. With the first fund, you’re paying less in taxes, but ending up with less money in your account after three years; the second fund generates a higher tax bill, while also yielding better gains after all is said and done. That doesn’t make it a cut and dried decision, but most investors, given the choice, would prefer more money in their account over writing a smaller check to the IRS.
Every client’s situation is different, and there are no universal rules to follow. At Adviser Investments, we work with each of our clients to achieve their individual goals. That said, there is some consensus thinking on the subject that any investor should consider.
Three Account Types to Know
Investment accounts generally fall into one of three classifications when it comes to the U.S. tax code: Tax-free accounts, tax-deferred accounts and taxable accounts.
Tax-free and tax-deferred accounts are appealing because income, dividends and other gains are allowed to compound untaxed. This greatly enhances the longterm growth potential of assets held in these accounts. The primary difference between tax-free and tax-deferred accounts is whether to pay taxes now or later. With tax-free accounts, including Roth IRAs, Roth 401(k)s and 529 college savings plans, you fund the account with after-tax dollars (paying taxes today), but the assets grow tax-free and you’ll owe no tax when it comes time to withdraw the assets.
With tax-free accounts, including Roth IRAs, Roth 401(k)s and 529 college savings plans, you fund the account with after-tax dollars (paying taxes today), but the assets grow tax free and you’ll owe no tax when it comes time to withdraw the assets.
Tax-deferred accounts like traditional IRAs and 401(k)s work the opposite way; you fund the account with pre-tax dollars but pay taxes (later) when you withdraw the assets.
Tax-free growth sounds great, so what’s the catch? Well, tax-free and tax-deferred accounts have penalties if you withdraw money either too soon (before retirement) or for purposes other than a few specific uses (e.g. college education). So in exchange for the tax-free compounding power you give up flexibility in accessing your money. And when you do begin making withdrawals, all of your investment gains in traditional IRAs and 401(k)s are subject to your income tax rate, not the lower capital gains rate.
The power of compounding without the bite of taxes is strong enough that for most investors it’s ideal to max out annual contributions to your tax-exempt and tax-deferred accounts if possible. Still, 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 the third type of account—a taxable account.
Every time an asset is sold in a taxable account for a gain, or you receive interest or dividend payments, you’ll have to pay taxes the following April 15. The two silver linings of taxable accounts? Losses can be booked against gains to reduce your tax bill. And though you’ll have to pay taxes along the way, you can take money from the account or add money to it without a penalty.
Tax Efficiency and Stocks
Broadly speaking, owning a stock gives you, the investor, greater control over the tax impact of profitable sales—at least in terms of when you’ll owe taxes. If you own a stock that has appreciated in price, you don’t owe taxes on those gains until you sell it. And holding a stock (or any asset, really) for at least 12 months before selling means those gains are considered long-term and taxed at a lower rate than if you’d held the stock for less than a year.
But even a long-held stock may still contribute to your tax bill. Stocks that pay dividends generate a tax liability for shareholders even if they are never sold. Around 420 of the 500 stocks in the S&P 500 index currently pay dividends.
Mutual Funds Can Be Tax Efficient
With mutual funds and ETFs you have some, but not as much, control over when you pay taxes. Similar to a stock, if you buy a fund and its price goes up, you don’t owe taxes on those gains until you sell shares of the fund. So the longer you hold a fund, the longer you can delay paying taxes.
However, there is a second layer to consider with a mutual fund or ETF. If the manager of the fund sells a stock that has gone up in price, that profit is passed along to fund shareholders, who ultimately pay the taxes on those gains. Mutual funds have to pay out capital gains at least once a year (if they have them), and as a shareholder in a taxable account there isn’t much you can do about it.
At this point you might think that if trades made by the portfolio manager lead to a big tax bill for you and me, then managers that don’t trade as much will have smaller tax bills. Lots of trading in a fund can lead to higher taxes, but it’s not a telling measure of tax efficiency: A high level of turnover (a standard measure of how often securities move into and out of a mutual fund) might mean the fund manager is harvesting losses—reducing the portfolio’s tax liabilities.
Index Funds Aren’t a Tax Cure-All
Many investors fall back on a basic rule of thumb that index funds will generate the smallest tax bills. And there is some truth to that, as index funds tracking the S&P 500 or other broad market indexes are typically among the most tax-efficient funds around. But even they too must buy and sell stocks when their benchmark constituents change. And those stocks still pay (taxable) dividends. In short, index funds are not immune from turnover or taxes, and the more narrow the benchmark the index fund tracks, the greater the potential for a tax surprise at year-end.
Just because many index funds are tax efficient and have low turnover doesn’t mean they’ll make you richer, faster. We believe, and our research bears out, that there are active portfolio managers who, despite generating a bigger tax bill, will also produce index-beating after-tax returns.
Tax Efficiency and Bonds
Bonds and bond funds are usually considered tax inefficient because a large portion of their return comes from monthly distributions of interest, which are taxed as ordinary income and thus are subject to an investor’s maximum tax rate. This is especially true when compared to stocks, where, in general, returns primarily come from price appreciation and are taxed at the capital-gains rate when shares are sold.
Some bonds do have tax advantages: Treasury bond income is exempt from state taxes but not federal taxes, while income from municipal bonds is tax-free at the federal level (and sometimes at the state level, depending on the issuer). Due in large measure to their built-in tax advantage, municipal bonds typically yield less than comparable corporate or Treasury bonds. However, for some taxable investors, the level of income paid by municipal bonds compares favorably to taxable bonds once taxes are taken into account.
Despite certain advantages that municipal and Treasury bond income offers, we (once again) urge you to prioritize after-tax gains over minimizing taxes. Corporate bonds can at times outperform a tax-exempt municipal bond even after you’ve paid taxes on the income from it. The easiest way to compare tax-free and taxable yields is to calculate a taxable-equivalent yield (the taxable yield you need to earn before taxes to equal a bond fund’s tax-free yield). You can calculate a taxable-equivalent yield by dividing the yield on a tax-free municipal bond by 1 minus the tax rate. For example, if a tax-free bond has a 3.0% yield and the tax rate is 25%, you’d need to find a taxable bond that yields at least 4.0% [3 ÷ (1 – 0.25) = 4.0] to make it worth the investment.
Taxes and Your Portfolio
As we said at the start, 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. Investors’ year-end tax planning should always encompass their entire financial picture and consider all of their investment accounts, a service we provide for our clients and one that we feel every experienced adviser should offer.
Sometimes, not making a move is the best choice—while it may be possible to save more on taxes in any given year, we think it’s more important to stick with a long-term strategy focused on maximizing your after-tax returns.
This material is distributed for informational purposes only; and is not financial or investment advice. Speak to your financial adviser before taking specific action. The investment ideas and opinions contained herein should not be viewed as recommendations or 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.
All investments carry risk of loss and there is no guarantee that investment objectives will be achieved. Past performance is not an indication of future returns. Tax, legal and insurance information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice, or as advice on whether to buy or surrender any insurance products. Personalized tax advice and tax return preparation is available through a separate, written engagement agreement with Adviser Investments Tax Solutions. We do not provide legal advice, nor sell insurance products. Always consult a licensed attorney, tax professional, or licensed insurance professional regarding your specific legal or tax situation, or insurance needs.
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