Managing investment taxes

Managing investment taxes

Managing investment taxes is an essential part of any good financial plan. For most clients, by far the largest expense incurred during their investment lifetime is income taxes. The goal of one’s tax planning should not be the avoidance of paying taxes per se, as few can do that. The goal should be to manage the taxation given each family’s unique circumstances and needs. How is that done? It starts with a high-level view of the household’s finances.

For instance, we believe all clients are well-served by having very broadly diversified investments. Diversification can help eliminate all but the most systemic of risks. A great way to achieve sound diversification is through mutual funds. A mutual fund pools the money of numerous investors to buy many different securities, giving its owners a proportional share of far more securities than could have been purchased individually.

For a mutual fund to become worthless, all of those many securities would have to become worthless faster than the fund management could sell them. This is a practical impossibility for any reasonably diversified fund.

One trade-off for this diversification is that there will be some taxation when funds are owned outside of retirement accounts. But by integrating good tax, investment, and financial planning, we can enhance diversification without ballooning the tax bill. The taxation of money in retirement accounts such as IRAs, Roth IRAs, 401(k)s, 403(b)s and the like is determined by deposits and withdrawals into or out of those types of accounts and is not related to the investments in the accounts.

…by integrating good tax, investment and financial planning, we can enhance diversification without ballooning the tax bill.

There are many aspects to mutual fund taxation in non-retirement accounts, also referred to as taxable accounts, but we will zero in on just two of the most important ones today – the type of securities owned by a fund and the manner in which the fund conducts its business.

The type of security affects the bottom line

For stocks, imagine you owned $100,000 worth of stock in each of three companies A, B and C in a taxable account. Company A pays a “non-qualified” dividend of 2%. Company B pays a “qualified” dividend of 2% and Company C pays no dividend.

Now let’s say you see the total return for each of them over the year was 10%. It would be easy to think all three contributed equally to your growing net worth. However, taxes make that untrue.

Company A’s $2,000 of non-qualified dividends are taxed at ordinary income rates, which range from 10% to 37%, resulting in a tax bill of $200 to $740 depending on the tax bracket. Company B’s $2,000 of qualified dividends are taxed at long term capital gain rates. Long term capital gain rates are lower than the rates on ordinary income for taxpayers at all income levels and range between zero and 23.8%, so the tax bill would be between nothing and $476. Company C pays no dividend, so no taxes are due this year regardless of the household’s income level.

For a household in the 37% marginal tax bracket, the net increase in net worth for the year for A, B and C would be 9.26%, 9.53%, and 10% respectively. This difference between pre-tax and after-tax returns is one of several examples of an effect known informally as “tax drag”. Company A has a drag of .74%, B’s is .46% and C’s has no drag.

A similar reduction from the reported returns is present with bonds and fixed income holdings. The interest on most bonds, CDs, money market, and cash accounts is taxable as ordinary income. By contrast, most bonds issued by state and local municipalities pay tax-exempt interest.

Say you are choosing between a taxable bond like a U.S. Treasury bond paying 2.5% in interest or a high-grade municipal bond (muni) paying 2% with the same maturity dates and selling at the same price. Which will produce the best return? That depends on your tax bracket.

If you are in the lower tax brackets, the 2.5% taxable interest will net more than the 2% the muni will pay. However, if you are in that 37% bracket, you only net 1.58% and the muni would have netted you more. In the 37% bracket, a taxable bond would have to pay 3.17% to equal the 2% interest on the tax-free bond. Another way this is stated is to say the municipal bond has a “tax equivalent yield” of 3.17% to our high-income taxpayer.

It is important to note that while non-dividend paying stocks and municipal bonds are by their nature more tax-friendly, this does not mean clients should avoid dividend-paying stocks or taxable bonds and CDs. Doing that would limit important diversification and increase one’s risk.

A better choice is to use tax-efficient funds and be strategic about which accounts hold the funds invested in less tax-friendly assets or use a less tax-efficient management style. We’ll leave the discussion of account strategy for another day, but how management style affects a Form 1040 ties in nicely to the topic of tax drag.

Management style affects taxes

Some investment products and approaches are inherently more or less tax-efficient than others based on how they are structured and operated. Strategies that require a lot of buying and selling, borrow to gain leverage, hedge with options or futures contracts, and those whose managers are free to make large bets or to add anything at any time all tend to produce more taxable income and capital gain distributions. (We wrote about capital gain distributions in our October 2014 newsletter.) The tax drag these gains create tends to be greater than the drag of more prudent, carefully structured long-term vehicles such as the types we recommend.

A recent study quantified the tax drag for high income taxpayers for over 2,400 mutual funds. The median difference between the pre-tax and after-tax returns over the ten-year period from November 2007 through October 2017 was over 1.1% per year. Fully 60% of the funds had a drag of at least 1% per year or more and fewer than 11% had a drag of less than ½%.[i]

This is not surprising to us because many fund management teams are more concerned with pre-tax returns than post-tax returns. The pre-tax returns are the returns you find in listings of funds. They are the returns most heavily advertised and are the returns upon which most consumers judge a managers’ performance.

(Pre-tax returns) … are the returns most heavily advertised and are the returns upon which most consumers judge a managers’ performance. In the real world, we can’t pay for groceries, mortgages, tuition, or health care with pretax returns.

In the real world, we can’t pay for groceries, mortgages, tuition, or health care with pretax returns. We pay for everything after we pay Uncle Sam. Maximizing the after-tax results in sensible ways is a high value endeavor.

Cents and sensibility

Cleary, ignoring taxation can be a detriment but obsessing over the tax bill can lead to issues as well. We have seen many educated people buy bad investment products and strategies because of the promise of tax breaks. The lure of lower taxes blinds them from a proper analysis of the underlying merits, or lack thereof.

Some investors buy deferred annuities to lower today’s tax bill only to get hit later. They buy rental property but can’t keep good tenants and are surprised to learn about recapture of depreciation later. They buy into an “exclusive opportunity” only to find out the investment is not liquid for more years than they imagined or worse, the whole operation is a Ponzi scheme or other sham.

Most of our clients are quite sensible and don’t take the tax bait. On our end, we actively incorporate tax issues into our financial planning and structure portfolios in ways that should produce good relative after-tax returns through careful selection of what we buy for clients. We review our clients’ holdings throughout the year looking for tactical opportunities which may arise when clients make deposits or withdrawals or the markets move significantly.

Good tax planning starts with good strategy but for us it doesn’t end there. Here, tax planning is an ongoing service.

[i] Gerstein Fisher Research