Reprinted with permission from Forbes.com.
Ben Franklin once said “in this world nothing can be said to be certain, except death and taxes”. Of course, he was right—taxes are an unavoidable part of life. This is particularly true in investing. But who wants to think about taxes? The word itself carries a negative connotation. Many investors distance themselves from the topic altogether as it can seem too ‘complicated’, ‘time consuming’, or ‘boring’.
But taxes are critically important. Improper tax management can cost you more than 25 percent of your long-term return, severely limiting your spending power in retirement. After-tax returns are all that matter—it’s what you keep that counts.
The good news is taxes can be managed. Just as eating healthy can help extend life, proper tax management can help extend portfolio values. Here are four key focus points for investors:
- Tax Efficiency
- Tax Allocation
- Tax Loss Harvesting
- Roth Conversion
There are thousands of investment vehicles to choose from, and each can have radically different tax implications. Knowing which are most efficient (and which are inefficient) is a vital first step in reducing your tax bill—it also helps filter your choices to a smaller, more reasonable list.
Mutual Funds are notoriously bad from a tax perspective. High turnover often creates large annual tax bills. According to Morningstar.com, the ten largest mutual funds by assets had an average turnover ratio of almost 75%. Most of these are actively managed funds where managers attempt to outperform a benchmark by selling winners to lock in gains. And the impact is clear. A 2010 study by Lipper (Taxes in the Mutual Funds Industry – 2010; Assessing the Impact of Taxes on Shareholder Return showed owners of mutual funds in taxable accounts gave up an average of 0.98 percent to 2.08 percent in annual return to taxes over the last 10 years. This is significant. As seen in the figure below, a difference of 1% over 10 years results in over $17,000 less on a $100,000 portfolio.
Worse yet, profits are usually distributed to shareholders once a year, so it is quite likely you will have to pay taxes on gains you didn’t even participate in. For more information, see Four Ways Mutual Funds Hurt Your Retirement.
Exchange Traded Funds
Exchange traded funds (ETFs) are generally more tax efficient than mutual funds. In fact, this is one of the primary reasons they were created. Unlikeactive mutual funds, most ETFs are passively managed which often translates into lower turnover, and thus lower tax bills. Certain passively managed mutual funds also fall into this category. But ETFs have another advantage: they trade on the secondary market like stocks and are structured to be easily created and redeemed. In other words, the securities that make up the ETF do not need to be sold to raise cash for redemptions. This largely eliminates the problem of forced distributions and results in greater tax efficiency.
Individual stocks, when properly managed, are the most tax efficient way to gain exposure to equities. They leave control over realizing gains entirely in the hands of the investor. Of course, certain stocks pay taxable dividends. But the choice to own dividend paying stocks is up to the investor—this is not the case with mutual funds or ETFs where investors lack control over underlying securities. Individual stocks can also be tax located more precisely.
Just like stocks, bond ETFs and passive bond mutual funds are generally more tax efficient than actively managed bond funds. But the tax treatment of income generated from bonds is different than equities. It is currently taxed as ordinary income, which can obviously be much higher than the rate on qualified stock dividends. However, there are exceptions. Municipal bonds arenot taxed at the federal level, and if you live in the state they are issued you can avoid state income tax as well.
Real estate investment trusts (REITs) are companies that invest in physical properties and assets. In general, they tend to focus on specific segments of the market such as retail, healthcare, and office properties. To qualify as a REIT, the company must payout at least 90% of its income (e.g. rental income) in the form of dividends. But unlike stocks, these dividends are generally taxed as ordinary income to shareholders.
Piecing It All Together
Is it always necessary to build a portfolio out of the most tax efficient vehicles? No. Like everything, there are tradeoffs. Many individual investors don’t have the time, knowledge, or savings to build portfolios of individual stocks—at least well-diversified ones. So sacrificing a little to Uncle Sam can make sense if it ultimately improves diversification. In these situations broad market equity ETFs can be great options given their tax advantages over most mutual funds.
Investors should also be careful with fixed income. Just because municipals are tax-free, it doesn’t mean they’re the best bonds to own. They most often make sense for individuals in very high tax brackets, where the tax benefits can outweigh their generally lower yields. Moreover, owning individual bonds isn’t always more efficient than funds. The fixed income market is generally less transparent and less liquid than equities. This means if you decide to sell before maturity you may have to realize a suboptimal price. Bonds also carry higher price tags than most equities, so it takes more money to build a well-diversified fixed income portfolio. Given these factors, diversified bond ETFs can be excellent options for most investors.
Real estate can provide valuable diversification benefits and should be considered its own asset class, separate from stocks and bonds. REITs represent an efficient way for investors to gain exposure despite the unfavorable tax treatment of dividends. They provide instant diversification and trade on the secondary market like stocks. They are much more liquid than physical properties and the investor is not responsible for ongoing maintenance and upkeep.
Tax efficiency is just the beginning. Proper tax management also means placing the right securities in the right accounts. This is called tax location. Depending on the underlying characteristics of the investment, you may be able to improve your annual return by strategically placing it in a taxable, tax-deferred, or tax-exempt account. The most common account types are shown in the figure below.
So what securities go where? One general rule is to place high yield stocks in tax-deferred or exempt accounts, like IRAs and Roth IRAs, and low yield stocks in taxable accounts. The reasoning is simple: the dividends can be reinvested and grow tax-free. And even though you might eventually pay taxes (when you withdraw money from a traditional IRA), the power of compounding can produce a higher annualized return over time.
Fixed income is a little trickier. While interest on bonds is taxed at a higher rate than stock dividends, their slower growth can actually make them better candidates for taxable accounts. The exceptions are bonds with higher yields, typically over 5 percent. Placing these in tax-deferred accounts can result in higher aggregate returns over time. REITs fall into the same boat—their dividends are not qualified and are taxed as ordinary income. Because of this and their higher growth profile, it is generally best to place REITs in tax-deferred or tax-exempt accounts.
The power of compounding returns should not be underestimated. This is particularly true for tax-exempt accounts. As such, it is generally best to place higher growth assets in a Roth to fully capture the benefit.
Tax Loss Harvesting
Tax efficiency and tax location provide a solid foundation, but disciplined portfolio maintenance can boost after-tax returns even further. We’re primarily referring to tax loss harvesting, which is the process of intentionally realizing losses to offset gains made within the portfolio. However, not everyone can participate. Obviously you need a taxable investment account, and the best results are realized through portfolios of individual stocks—there is a better chance of having both winners and losers.
It’s slightly counterintuitive. After all, you’re supposed to sell high, right? But the idea is not to eliminate exposure entirely. It’s only a temporary sale to reduce your tax bill, after which you buy back the same stock. The only caveat is you must obey the 30 day wash sale rule. This states that in order to claim the loss, you cannot purchase the same security within 30 days before or after the sale. You also can’t buy a new security that is essentially the same. For instance, if you sold an S&P 500 Index ETF to claim a loss, you can’t turnaround and buy a new S&P 500 Index ETF from a different provider (e.g. Vanguard for iShares). But if you sold a handful of stocks, you could certainly buy a broad-market equity ETF in their stead. You would then hold it for 30 days to maintain stock exposure.
Tax loss harvesting can be a tremendously helpful portfolio management tool. As previously mentioned, a portfolio of stocks is likely to have both winners and losers in any given year. If left untouched, this can lead to material portfolio deviations. Tax loss harvesting creates an opportunity to rebalance the portfolio back to model weight—you can claim losses and simultaneously pare down winners with large embedded gains. And if you don’t have any gains to offset, you can deduct up to $3,000 in losses from your taxable income. The end result is a higher net after-tax return.
One of the more common tax management questions, at least in recent years, is whether to convert a traditional IRA to a Roth IRA—also called a Roth conversion. On the surface a Roth might appear superior. After all, its tax-exempt nature amplifies compounding investment returns over time. Unfortunately, the answer isn’t this simple. A number of criteria must be met before a Roth conversion makes sense.
The most important factor to consider is future tax rates. This is because when you convert to Roth, you pay ordinary income tax on every investment converted. Remember, Roth IRAs are funded entirely with after-tax dollars. Only growth and withdrawals are tax-exempt. So if you expect your future tax rate (in retirement) to be lower, which it often is, converting and paying taxes now as opposed to later might not make sense.
A Roth conversion can also generate a large tax bill—it matters how you go about paying it. Since a Roth enjoys tax-exempt growth, a greater benefit is realized over time with a higher initial balance. Much of this is erased if you pay taxes out of the actual IRA balance. In other words, a Roth conversion is more impactful if you can pay the tax bill with an outside non-retirement account, like an individual or joint account.
Another factor to consider is time horizon. The longer the time frame for the assets the greater the benefit of compounding returns. Put simply, the longer you hold off on making withdrawals, the better. Roth’s can also be great ways to pass on assets to heirs because they are not subject to minimum distributions. This allows more assets to grow tax-free for longer.
So if you expect your future tax rate to be higher, can pay the tax bill with non-retirement assets, and have a long time horizon, a Roth conversion might make sense. But it’s always a good idea to consult with tax and investments professionals before making such a decision.
Proper tax management seems complicated, but a few basic steps can make a dramatic impact on your long-term wealth. Focus on tax efficient vehicles, place them in the proper account types, and harvest losses to offset gains, where possible. And if you’re a good Roth conversion candidate, your picture can look even brighter.
*The advice provided is for informational purposes only. Investors should always consult a tax professional for a more accurate assessment of their personal situation.