Reduce or postpone taxes for better portfolios
I always see investors worry about whether their portfolios are keeping up with benchmarks such as the Standard & Poor’s 500 Index.
Yet many ignore the bite taxes can take out of their returns – even though these costs may outweigh any short-term losses caused by underperformance.
Investors who fail to consider taxes in crafting their investment strategy risk doing serious harm to their long-term financial prospects.
Taxes may be inevitable, but I have identified a couple of ways potentially to reduce – or postpone – them.
But crafting a successful “tax sensitive” investment strategy is a complex business. Many factors can affect tax liabilities – such as the kinds of assets held in a portfolio, how long those assets can be used to offset taxable gains. Different investment vehicles, such as mutual funds and separately managed accounts, are also treated differently under the tax laws. So tax strategies available to some investors may not be available to others.
I found a study that illustrated the bite taxes could take out of returns.
It shows the growth over 30 years of a hypothetical $100,000 investment by a tax-exempt investor and by an investor in the top federal tax bracket.
The example assumes both accounts are invested in an equity portfolio earning a 13 percent annual return – roughly the average for the S&P 500 over the past 30 years. Of that return, 10 percentage points are in the form of capital gains and 3 percentage points are in dividends. The study also assumes both investors convert to cash or “realize” 50 percent of the gains they earn each year.
I couldn’t believe the results! While the tax-exempt investor would see a $100,000 investment grow to nearly $4 million, the taxable investor would finish with just over $1.65 million, almost a 60 percent reduction in returns.
Many analysts say investors should try to improve their “tax efficiency” by reducing the difference between their pre-tax and after-tax returns as much as possible. But I think focusing only on tax efficiency can more than offset any tax savings.
Some assets pay lower returns precisely because they are tax efficient. Municipal bonds, for example, pay interest that is not subject to federal tax. But because of this feature, municipal bonds generally are priced above similar U.S. Treasury bonds. Higher prices mean lower yields, offsetting the tax savings.
Basing investment decisions strictly on tax considerations also can leave investors holding portfolios that are not adequately diversified.
Some advisors, for example, suggest investing solely in stocks that pay little or no dividends but are expected to show large capital gains.
The logic behind this advice is straightforward: Capital gains are highly tax favored under the current tax code.
Gains on assets held more than a year generally are taxed at a 20 percent rate, far below the 39.6 percent top rate on interest, stock dividends and short-term capital gains.
Capital gains also are not taxed until assets are sold, meaning those assests can grow and compound tax free.
These are important benefits. But investing solely in stocks can mean sacrificing the risk reduction that historically has been obtained through portfolio diversification. Over the past two decades, we have witnessed several cycles in which high-yielding “value” stocks outperformed gains-producing “growth” stocks.
An investor who purchased an all-growth portfolio just before the start of a value cycle might see a long period of sub par performance offsetting any tax savings.
Another common mispercepton is that the key to avoiding taxes is keeping portfolio turnover as low as possible. The term “turnover” refers to how frequently portfolio managers buy and sell stocks or other securities. This typcially is measured by dividing the value of all securities sold during a year by the value of the portfolio’s total assets.
Because capital gains are taxed when assets are sold, a low turnover strategy does tend to push tax liabilities into the future. A buy-and-hold strategy also makes it more likely your gains will be taxed at the long-term 20 percent rate.
But a certain amount of portfolio turover is inevitable, even desirable. One example is the realization, or “harvesting” of capital losses. This increases turnover, but can be an effective strategy for limiting taxable capital gains.
Realized capital losses not only can be used to offset capital gains, they also can be used to shelter up to $3,000 per year in ordinary income. Tax losses that cannot be used in one year can be carried over to later years.
Some index funds – such as those that track small-cap benchmarks or a particular equity style – actually have fairly high rates of turnover. This is because the stocks in those benchmarks can change fairly quickly.
I see the index changing predominantly because a company’s size bumps it out of one index and into another, and secondly, to reflect changing market and economic conditions.
I have found that separately managed accounts can give investors considerable control over the timing of capital gains and losses, because assets held in those accounts remain their personal property. This means their tax liability cannot be affected by the actions of other investors. For information, call me at 689-8720.
William Creekbaum, MBA, CFP, a Carson City resident, is senior consulting group associate of Salomon Smith Barney, a financial services firm serving Northern Nevada.