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Taxes, the silent killer of Investment Returns

Financial Planning

The great inventor and statesman, Benjamin Franklin, once said: “In this world nothing can be said to be certain, except death and taxes.” When it comes to your investments, taxes can rarely be avoided, but there are ways to minimize them. There are other impediments to investors’ returns over time: investor emotions, fees, or acting on your neighbor’s hot stock pick. We’ve probably all experienced these issues over time, and at the extremes they can all be detrimental.

Taxes, however, are the silent killer of investment performance. They don’t show up on your monthly statement, they take some significant effort to calculate their effect, and at the extreme can eat up more than half your annual investment performance.

As ordinary income and capital gains taxes climb for investors in the highest tax brackets, the effect on investment returns continues to grow. For example, a couple in California in the highest federal tax bracket and achieving an 8% return on their investment portfolio could see more than half their gains eroded by taxes.

So, how do you improve after-tax returns?

Municipal Bonds

Generate income that is federally tax-free through Municipal Bonds, and in some cases, state tax-free as well. For the Fixed Income portion of your portfolio, the best comparison is Municipal Bonds vs. Treasury Bonds vs. Bank CDs. Treasury bond income is exempt from state taxes but is subject to federal income taxes, while Bank CDs are subject to both state and federal taxes. For investors in the 25% tax bracket or higher, Municipal Bonds are often more attractive on an after-tax basis. A CD yielding 5% gets cut in half due to taxes…not overly attractive!

Index Funds

Until sold, Index Funds are tax-efficient, realizing very few taxable gains in a given year. While an actively managed fund may outperform the benchmark, they often have a higher portfolio turnover and tend to generate taxable short and long-term gains. Once Uncle Sam takes his cut of the fund’s distributions, the actively managed fund must not only beat the index fund it must overcome the tax consequences as well. Some active funds can be tax-efficient, so best to consult with your advisor.

Asset Location Optimization

The process of owning tax-efficient investments in a taxable account and owning tax-inefficient investments in a retirement account. If you think High Yield bonds are attractive, it is better to own them in your 401k or IRA, as all the interest would be treated as ordinary income. In contrast, it makes sense to hold municipal bonds in taxable accounts given their tax advantages.

Tax Loss Harvesting (Related: Tax Loss Harvesting: Decreasing your Tax Liability While Enhancing your Portfolio)

A portfolio of 20 holdings will rarely have all 20 moving up at the same time. Last year, for example, the S&P 500 dropped 19%, presenting a Tax-Loss Harvesting opportunity. By selling the position and purchasing a sufficiently similar position, the investor maintains their exposure to the asset class.

Don’t sell significantly appreciated assets

They generally get a new cost basis equal to the date of death value. Thus you and your heirs can avoid capital gains taxes on the appreciation. However, it is ok over time to sell appreciated positions if they skew the risk in your portfolio.

All investments are subject to risk. Unfortunately, tax risk is often overlooked. By understanding how taxes effect investments and different strategies to minimize them, an investor can mitigate some of that risk.
 

The information provided is not written or intended as specific tax or legal advice. Lenox Advisors, its employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.

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