Income taxes usually represent an investor’s single-greatest investment cost. However, many individuals focus solely on their returns, not on how taxes are affecting those returns. Some investors don’t consider that the taxes they are paying on the dividends, interest and their investments’ realized capital gains can reduce the value of their portfolios.
Tax-efficiency can optimize your portfolio’s potential for long-term growth. The key to tax-efficient investing is maximizing your after-tax return while minimizing your tax burden. Understanding a few basic principles of tax-efficient investing can also help you maintain control of your portfolio’s performance.
One of the most common tax-efficient strategies centers on the amount of securities trading that active portfolio managers undertake. This trading activity, or turnover, forces investors to recognize capital gains on appreciated securities. For example, a $1 million portfolio that generates 10 percent annual returns and is traded every year would yield $4,016,940 after taxes at the end of a 20-year period. This is equal to a 7.2 percent annual return, even assuming all gains are long-term. But tax-efficient investing uses structured, less-frequent turnover to provide desired returns along with a lower tax burden. The same portfolio traded only once at the end of a 20-year period would yield $5,123,800 after taxes. This is equal to 8.5 percent annual return.
SELL BEFORE YEAR-END DISTRIBUTIONS
Selling a fund you have owned for more than a year before year-end distributions may provide tax savings. If you sell the fund before the dividend date, the gain is taxed at the long-term rate of 20 percent, whereas the short-term rate and the ordinary dividend rate can be as high as 39.6 percent. Selling a fund before distributions are made also may allow you to generate either short or long-term capital losses, which can counterbalance your capital gains and thereby minimize taxes.
BE AWARE OF YOUR PORTFOLIO
You should be aware of your investment holdings and their inherent tax implications. For instance, if you hold taxable bonds for the purpose of generating income, consider the income tax consequences. Bond income is taxed as ordinary income — at rates as high as 39.6 percent. You should weigh the benefit of receiving current income at a high tax cost against the lost opportunity for tax-deferred capital appreciation through investment in equities. In some situations, bonds may still be the right investment choice, but you must consider all relevant return factors to structure a portfolio to best suit your needs.
LIMITATIONS OF TAX-EFFICIENT INVESTING
There are, however, limits to the principle of tax-efficient investing. Taxes alone should not drive your investment decisions. Even though reducing portfolio turnover can increase tax efficiency, you shouldn’t hold a stock or fund beyond its potential. Selling a security you feel has reached its peak and realizing a gain could improve your portfolio. Even after taxation, you might find more profitable alternative uses for the realized gain.
COMMUNICATE YOUR NEEDS
When structuring your portfolio, you can consider numerous hybrid strategies. The possibilities are limited only by your or your advisor’s imagination. Before deciding on a strategy, analyze your investment goals. If you feel your current strategy isn’t meeting your after-tax return expectations, discuss it with your portfolio manager. Understanding the principles of tax-efficient investing will help you or your advisor structure a portfolio that best suits your goals and provides optional returns.