Too often I meet investors who assume they earned a decent rate of return, only to discover their returns were actually much lower once they accounted for costs like management fees and transaction fees. Another cost investors sometimes overlook is the impact taxes can have on their portfolio. Remember, after-tax returns are what matters. It’s what you keep that counts. One study found that over the last ten years, investors in taxable mutual funds gave up 0.98 percent to 2.08 percent on an annual basis because of taxes alone.1 That may not sound like a lot, but compounded over many years, it can be quite significant and can limit your spending power in retirement. The good news is there may be some steps you can take to mitigate the tax impact on your portfolio. Here are four tips to consider:
- Asset location
- Tax loss harvesting
- Rebalancing frequency
First, it is important to understand what type of investment is most appropriate for each type of account. Interest income currently gets taxed at a 39.6 percent rate for investors in the highest bracket; however, dividends and capital gains get favorable tax treatment and are taxed at a maximum rate of only 20 percent. It might make sense, therefore, to hold equity investments that generate returns from both dividends and capital gains in a taxable account. If, instead, you held those same investments in a tax-deferred account such as a 401(k) or IRA, the capital gains and dividends would lose their favorable tax treatment because they would be taxed at the ordinary rate when withdrawn. You might consider holding investments such as high-yield bonds in a tax-deferred account since the interest is subject to ordinary income tax rates anyway, and in the meantime, any growth remains tax-deferred. Tax-free municipal bonds are usually more appropriate for taxable accounts, since holding them in a tax-deferred account will result in the loss of the tax-exempt interest. Tax-free municipals are also typically more appropriate for investors in higher tax brackets since they generally offer lower yields than similar-risk taxable bonds.
If your portfolio declines in value in a given year, it may surprise you to learn you may still owe capital gains taxes. Sometimes this can be attributed to turnover - how frequently assets are bought or sold. Imagine you have a portfolio consisting of 80 percent bonds and 20 percent equities. If the bonds declined in value and the equities increased in value, your overall portfolio may have declined due to the larger allocation to bonds. If you or your advisor sold some of the equity positions that appreciated in value, you may owe taxes on those gains because you have now turned "unrealized" gains into "realized" gains. If you held the assets for one-year or less before selling, you could owe short-term capital gains on the sale. Short-term capital gains are taxed at your ordinary income tax rate, currently up to 39.6 percent. If you held the assets for more than one year before selling, you may owe long-term capital gains, currently taxed at a maximum rate of 20 percent. Turnover also occurs in other investment vehicles like mutual funds. If the mutual fund manager sells holdings that have appreciated in value, it can trigger realized capital gains. Imagine a mutual fund consisting of 300 underlying stocks, some of which performed well, while others did poorly. The overall fund may have declined in value; however, the manager may have sold some of the "winners" within the fund, and in doing so, the fund "realized" gains. Since mutual funds are technically pass through entities, they are required to pass at least 95 percent of their net gains to investors. That means you could owe long- and/or short-term capital gains depending on how long the manager(s) held the stock(s) even though the overall fund underperformed. This is one reason I favor mutual funds with low-turnover such as index funds or asset-class funds. Not only are the management expenses on these funds generally lower, but the trading activity also tends to be lower, which can reduce internal transaction costs and investors’ tax liability. Lower costs may be one reason most index funds funds have outperformed the vast majority of actively-managed funds over the last decade.2
In an ideal world, investments would always appreciate. But that's not reality. Tax-loss harvesting enables you to make lemonade out of lemons by allowing you to offset investment gains with investment losses. If your losses exceed your gains, you can use remaining losses to offset up to $3,000 of ordinary income each year. One potential downside to tax loss harvesting is that it can go against the old adage "buy-low, sell-high."
Rebalancing is a structured way to sell off some assets that have appreciated in value and buy assets that have declined in value. Rebalancing is important because it can help keep the allocation in line with your overall plan and your risk tolerance. Some studies suggest that rebalancing can have a positive effect on potential long-term investment performance.3 But rebalancing too frequently can increase costs, including trading fees and taxes, thus reducing your net rate of return. I recommend reviewing your portfolio quarterly (or at least annually) to evaluate rebalancing opportunities; however, it is not something you necessarily need to do weekly or monthly. If you anticipate your income will be lower in a given year, it might make sense to rebalance your portfolio and enjoy potentially lower capital gains treatment on long-term capital gains. Or if you have a combination of taxable accounts and tax-deferred accounts earmarked for retirement, you might manage the accounts as a single allocation and do most of your rebalancing within the tax-deferred accounts.
Selling an investment for tax purposes is an important consideration; however, it should never be the sole reason for making investment decisions. A written Investment Plan can help give you confidence in your investment strategy, and reviewing it each year with your financial advisor and accountant can help keep you on track to achieving all that is important to you financially. Your advisors can help you balance the tax benefits of certain investment decisions with your long-term objectives. As we approach the end of the year, this is a great time to review your plan.
1. Lipper Research, “Taxes in the Mutual Fund Industry–2010: Assessing the Impact of Taxes on Shareholder Returns.
2. SPIVA U.S. Mid-Year 2016 Scorecard. https://us.spindices.com/documents/spiva/spiva-us-year-end-2016.pdf.
3. Campbell, John Y, Joao Cocco, Francisco Gomes, and Pascal J. Maenhout, and Luis M. Viceira, "Stock Market Mean Reversion and the Optimal Equity Allocation of a Long-Lived Investor." 2001.
The material contained herein is for informational purposes only and does not constitute tax advice. Investors should consult with their own tax advisor or attorney with regard to their personal tax situation