Taxes, the silent killer of Investment Returns
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.
The Federal brackets graduate from 10% up to 37% while the California brackets graduate from 1% to 12.3% with an additional 1% surtax on taxable income over $1,000,000. Assuming the 8% is taxed as ordinary income or short-term capital gains, the Federal government will impose a 37% tax rate to the earnings over $600,000 for joint filers. At $600,000, California will impose an additional tax of at least 10.3%; and the Affordable Care Act (aka Obamacare) could add another tax on that return at 3.8%. All told, an 8% return could be whittled down to 3.9%. As investors, we then have to ask ourselves, is the risk we are taking to achieve the 3.9% return worth it?
So, how do you improve after-tax returns?
Generate income that is federally taxfree through Municipal Bonds, and in some cases state taxfree 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 CD’s 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 1% gets cut in half due to taxes…not overly attractive!
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 funds 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. The California client on the previous page would avoid any current taxes if they owned their investment in an IRA. If you think High Yield Bonds are attractive, better to own them in your 401K or IRA, as all the interest would be treated as ordinary income.
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 summer International stocks dropped 14%, 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. The loss can be used to offset against gains realized by other positions throughout the year. For example, realizing a $10,000 loss has almost a $4,000 tax benefit. While tax loss harvesting is impactful at high dollar amounts, remember commissions effect your basis and return
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. Lenox Advisors, Inc. (Lenox) is a wholly owned subsidiary of NFP Corp. (NFP), a financial services holding company, New York, NY. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 90 Park Ave, 17th Floor, New York, NY 10016, 212.536.6000. Fee based planning services are offered through Lenox Wealth Advisors, LLC (LWA), a registered investment adviser. Services will be referred by qualified representatives of MML Investors Services, LLC (MMLIS). LWA is a subsidiary of NFP and affiliated under common control with Lenox. Lenox, LWA and NFP are not subsidiaries or affiliates of MMLIS, or its affiliated companies. FP178 CRN202108-251729