The Ultimate Tax Guide To Maximize Investment Returns - Personal Capital

Seth for Young Investors of Today writes: Recently I’ve signed up for Personal Capital, and I am very impressed. If you want to aggregate several accounts to track your finances, then Personal Capital is for you. And it’s free (they make their money by advising certain clients as certified investment advisers). I also found a review that very accurately puts it: “Personal Capital is best described as an “aggregator.” It exists to help you track and understand your financial accounts,” and “It is similar to Mint’s online service, but will much more investment input. If you have any investment information, Personal Capital picks up where Mint leaves off.” (And no, they aren’t paying me to say this, they’re just that awesome.)

I also decided I wanted to look more into what they have to say about taxes, and I am, once again, impressed. I decided to dedicate today’s blog post to an article written by Brenden Erne, CFA back in February that covers some basics on managing your investment account to minimize your taxes. Have a look:

Taxes are consistently one of the top recurring expenses in everyday life – more so than a mortgage, a car payment, or even an egregiously priced private school.

Given the government takes away more in taxes than most Americans save a year, it behooves all of us to figure out how to minimize our tax liability to grow our wealth. Just as eating healthy can help extend life, proper tax management can help extend portfolio values. There are various tax strategies one can employ to maximize their investment returns.

Here are the five most important tax issues for investors:

• Tax Efficiency
• Tax Allocation
• Tax Loss Harvesting
• Roth Conversion
• Long-term Focus

In the following post, I review each of these issues and provide guidance on how to incorporate them into a successful tax strategy for an investor.  I also outline Personal Capital’s capabilities in each arena and describe how we account for each in the portfolios of our investment clients.

1) Tax Efficiency

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

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. Unlike active 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

Individual stocks, when properly managed, are the most tax efficient way to gain exposure to equities. There are also no ongoing fees associated with owning a stock, unlike owning a mutual fund or ETF. After paying for a transaction cost that is almost always under $10 no matter how much you spend, that’s it.

Stocks leave control over realizing gains entirely in the hands of the investor. Of course, certain stocks pay taxable dividends – but they’re tax efficient since they are taxed at a lower rate than capital gains. But the choice to own dividend paying stocks is up to the investor, which 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 (read on to learn what that means).

Bonds

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 bond income is different than that of equity income. Bond income 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 are not taxed at the federal level, and if you live in the state where they are issued, or if you live in one of the seven no income tax states, you can avoid state income tax as well. Municipal bonds are obviously more attractive for individuals in the highest federal income tax brackets. Just be aware of the inverse relationship with municipal bond performance and interest rates – i.e., in a rising interest rate environment, bonds tend to decline in value as their coupon payment is less attractive.

REITs

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, a designation that means no corporate tax for the company, the company must payout at least 90% of its income (e.g. rental income) in the form of dividends. That means that REIT investors are not “double taxed” – which is the case with most equities, where an investor pays tax on dividends that are distributed only after the company has already paid taxes on its earnings.  The catch: these dividends are generally taxed as ordinary income to shareholders.

How a Personal Capital advisor can help you: For each of our clients, Personal Capitalbuilds a unique portfolio that is efficient not only from a risk and return perspective but also from a tax perspective.  Each portfolio is on the efficient frontier; meaning its component securities represent a blend of asset classes that maximizes the risk-adjusted return.  For each client, we ascertain the appropriate level of risk for the client after a thorough review of their financial situation, risk capacity and household financial goals. Second, we maximize tax efficiency of these portfolios by investing in low-cost ETFs and individual securities and avoiding mutual funds.

2) Tax Allocation

Tax efficiency is just the beginning. Proper tax management for investors 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 tax-advantaged account types are shown in the figure below.

So what securities go where? Let’s start with equities. One general rule is to place high yield stocks in tax-deferred or tax-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 their tax treatment 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 your highest growth investment assets in a Roth to fully capture their compounding benefit.

How a Personal Capital advisor can help you: Personal Capital invests both through taxable and different types of tax-exempt and tax-deferred accounts on behalf of our clients.  We’ll even advise on held-away accounts – like 401ks – as part of our overall approach.  And across all of the household accounts of our clients, we make sure that the right securities end up in the right accounts so that our clients not paying unnecessary taxes on income-generating securities and can enjoy that extra growth pre-tax.

3) Tax Loss Harvesting

Tax efficiency and tax location provide a solid foundation for your tax strategy, 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.  Your tax bill is paid on the net amount. Further, if you don’t have any gains to offset, you can deduct up to $3,000 in losses from your taxable income.  Given the recent increase in the capital gains tax rate for those in the top income tax bracket (39.6%), if you’re below that level today, harvesting gains may make more sense more than ever.

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 (i.e., away from the intended allocation). 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.  The end result is a higher net after-tax return.

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.

However, not everyone can participate. First, you need a taxable investment account.  And second, the best results are realized through portfolios of individual stocks, where there is a better chance of having both winners and losers.

How a Personal Capital advisor can help you: At Personal Capital, we do regular tax loss harvesting for all of our clients.  We use software that enables us to view tax loss harvesting opportunities in all of our clients’ portfolios on a daily basis, and we make trades when appropriate.  Because a decent portion of all of our clients’ portfolios is invested in individual securities, we have tax loss harvesting opportunities even when the market is rising.

4) Roth Conversion

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. As we’ve written on Daily Capital in Roth IRAs and 401ks: Are They a Smart Move for You?, 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—so it matters how you go about paying it. Since a Roth enjoys tax-free 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 or with cash.

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, if you can pay the tax bill with non-retirement assets, and if you have a long time horizon, a Roth conversion might make sense. You’ve also got to get comfortable with the idea of giving more money to the government who has shown to not be the most efficient allocator of resources. It’s always a good idea to consult with tax and investments professionals before making such a decision.

How a Personal Capital advisor can help you: For each of our clients, we help with determination of what type of retirement account makes the most sense.  We do this both when clients open accounts and over time when a conversion may make sense.

5) Long-Term Focus

Finally, it’s worth noting that it’s generally better to take a long term investment view due to the way capital gains are taxed. If you sell a security within 12 months, any profits you make will be considered short-term capital gains and taxed at your ordinary tax rate of 10%, 15%, 25%, 28%, 33%, 35%, or 39.6%.

If that’s not enough, there’s a 3.8% net investment income tax on those who make over $200,000 if you file single or as head of household, $250,000 if you’re married filing jointly, or $125,000 if you’re filing separately.

For those who hold their security for at least 12 months and a day and then sell, there’s much more favorable long-term capital gains tax rates. For example, if you’re in the 10% or 15% marginal income tax bracket, your long-term capital gains tax rate is 0%. You can’t beat that. For the 25%, 28%, 33%, or 35% marginal income tax brackets, your long-term capital gains tax rate is 15%. And for the 39.6% marginal income tax bracket, your long-term capital gains tax rate is 20%.

Piecing it All Together

Proper tax management seems complicated, but a few basic steps can make a dramatic impact on your long-term wealth. Prioritize tax efficient vehicles, place them in the appropriate accounts, and harvest losses to offset gains, where possible. Invest with a long-term orientation, and keep a Roth conversion in mind.

Improper tax management, on the other hand, can cost you more than 25 percent of your long-term return, severely limiting your spending power in retirement.

Our advisors can help you design and implement the optimal tax strategy for your portfolio.  After all, it’s your after-tax returns that matter—it’s what you keep that counts.

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