In our recent webinar on the future of tax management, we discussed the evolution of tax management, tax management techniques and action steps advisors can take today to manage for taxes more efficiently. We followed that up with a white paper on tax management, The Keys to Building More Tax-efficient Portfolios.
We pay a lot of attention to taxes for good reason, as they can result in the loss of up to 60%1 of investor’s return over time. That is a staggering result – and one worth trying to nullify through various tax management techniques.
A constantly evolving tax code
Taxes on investment income are more complex than they were two decades ago. The passage of healthcare legislation and the expiration of recent tax cuts led to higher tax rates in 2013, with the top federal long-term capital gains rate increasing from 15% to 23.8%, an increase of 59%2.
As the U.S. continues to deal with rising federal budget deficits and underfunded entitlement programs, we believe that initiating tax strategy conversations with clients will become increasingly important in the years ahead.
There is a better way – year-round
Tax-efficient investing is a sensible strategy for many investors – especially those with high marginal tax rates or concentrated equity holdings. Tax efficiency is a measure of how much of an investment’s return remains after taxes are paid. The greater the tax efficiency, the more gains an investor keeps. The goal is not to avoid taxes, but to defer the realization of gains to maximize overall after-tax returns.
Too often, financial advisors focus only on reducing taxes in November and December, at which point options are limited, because they have surrendered the other 10 months of the year and lost the opportunity to employ tax management during that time.
Think about asset location vs. asset allocation
While asset allocation is one of the most important drivers of overall returns, many fail to appreciate the importance of “asset location” – the process of deciding which investments to hold in a taxable account and which to hold in a tax-favored account. The optimal choice should consider the investor’s goals and marginal income tax bracket (including whether the investor is subject to the alternative minimum tax), the asset class, the tax characteristics of the underlying assets and the types of accounts owned.
Taxes are the single largest drag on performance for investors over time3, so, to keep taxes low, it pays to be strategic about your asset location. Where financial assets (account type) are held can make a big difference in what gets kept versus what is forfeited in taxes.
The impact of taxes
Bearing in mind the features of these account types, consider the different tax consequences of each approach illustrated here.
In this hypothetical example, we show the growth of $100,000 invested in the SPDR Trust Series (NYSE: SPY) from 1995-2015 – an ETF that tracks the performance of the S&P 500 index – for four different portfolios. The results range from a portfolio that pays no tax for capital gains or dividends, to one that pays the highest tax rates.
Performance reflects fund fees but does not show the effect of other fees associated with investing, including those fees your advisor charges, which would reduce performance, particularly when compounded over a period of years. The following hypothetical illustration shows the compound effect fees have on investment returns: For an account charged 1% with a stated annual return of 10%, the net total return before taxes would be reduced from 10% to 9%. A ten year investment of $100,000 at 10% would grow to $259,374, and at 9%, to $236,736 before taxes. For a complete description of all fees and expenses, please refer to each of SIMC’s and the Financial Advisor’s Form ADV Part 2A.
Source: Parametric. The chart in Figure 1 illustrates the effect of taxes on an investment that tracks the S&P 500 Index. The hypothetical results assume the highest marginal federal tax rates, 43.4% short-term rate and 23.8% long-term rate. State and local taxes are not considered. For “Gains Taxed at Short-term Rate” all investment gains are realized immediately and taxed at short-term rates. “Gains Taxed at Long-term Rate” assumes investment gains are held until they qualify for preferential long-term capital gain rates. Finally, “No Taxes” shows the return associated under an assumption of zero taxes—the theoretical limit of tax efficiency. In all scenarios, dividends are taxed at the long-term rate, except in the assumption of zero taxes. Taxes are paid annually from the portfolio and values are presented on a pre-liquidation basis. No representation is being made any investor will achieve the tax savings presented. Actual client after-tax performance will vary according to each investor’s unique tax circumstances.
These are hypothetical examples intended to illustrate the effect of taxes and tax management on a portfolio. The methodologies used are not necessarily available to all investors. Results would vary based on individual investor circumstances.
In the hypothetical example in Figure 1, the “no taxes” portfolio earned about $650,000 in gains over 20 years; the “gains taxed at short-term rate” portfolio earned less than half of that amount ($278,699 after taxes). By holding the assets in the most tax-favored account type, actively monitoring the portfolio and harvesting losses, the investor can keep more money working longer, as the tax savings can be reinvested and compounded over time. That’s a difference of approximately 50%!
To mitigate the impact of taxes on accounts, utilize tax managed mutual funds, ETF strategies that offer tax loss harvesting and managed account solutions that offer a tax overlay provider to manage for taxes. Finding an outsource partner that does all these things can make your life easier.
Here are four steps you can take now to help build more efficient portfolios:
- Supplement year-end reviews with a year-round tax strategy.
- Examine client tax returns paying special attention to the Form 1099, Form 1040 and Schedule D, to assess the capital gains and losses reported.
- Evaluate clients’ asset location. Take inventory of all financial accounts, including mutual funds, annuities, retirement plans, life insurance policies and savings accounts.
- Re-examine your clients’ goals to reflect significant events (e.g., birth of a child, job change, marriage or divorce, inheritance, stock options awards, etc.), as well as any changes in their viewpoint on saving taxes, budgeting or other financial issues.
Want to learn more? Access our tax management white paper.
1Source: Parametric Portfolio Associates . Based on a hypothetical tax-free $100,000 portfolio invested 60% in stocks (based on the Russell 3000®) and 40% bonds (based on the Barclays Aggregate) with (1) no liquidators; (2) interest income and dividends taxed annually at historical top marginal tax rates; (3) capital gains realized at 50% per year and taxed at the historical long-term capital gains tax rate; and (4) portfolio is held for 36 years from (1979–2015). The intent is to portray a worst-case scenario. The portfolio would have grown from $100,000 to about $4.0 million. If the portfolio was taxed as indicated above, it would have lost 60% of its value, due to taxes paid and earnings lost on that money. Tax-managed investment strategies are designed to minimize capital gains distributions and maximize after-tax returns. Past performance is no guarantee of future results.
2American Taxpayer Relief Act of 2012, Affordable Care Act of 2010, IRS.
3Arnott, R; Berkin, A; Bouchey, P. “Is Your Alpha Big Enough to Cover Its Taxes? Revisited.” Investments & Wealth Monitor, January/February 2011.
Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor