You may have heard a common investment expression ?It's not what you make that counts. It's what you keep.? Minimizing taxes from investment activities is important because it's one of the few aspects of investing that an investor can gain virtually total control over. Paying attention to the tax consequences of investing can substantially increase long-term wealth and increase spendable income. This article will address various investment strategies and products for minimizing taxes.
Stocks should be held (owned) to the extent possible in taxable accounts. This is due to four reasons; Stocks are taxed on dividends and realized capital gains only, whereas if the same stock or equity fund is held in an IRA, upon distribution, the total return is fully taxable. Second, the tax rates applied to dividends and capital gains are lower than the ordinary income tax rate associated with withdrawals from tax-deferred accounts. Third, upon death, there is a step up in basis on stocks, eliminating the capital gain liability. This is not available if stocks are owned in tax-deferred accounts. Fourth, there is an opportunity, in taxable accounts, to use tax loss harvesting to further reduce capital gains tax liability. This isn't available in tax-deferred accounts.
Even among index funds, some are more tax-efficient than others. If an asset allocation involves placing a portion of the equity allocation in a tax-deferred account, the least tax-efficient funds should be placed there first; For example, REITS, or an international small value fund (for which there are no tax-managed funds), are better served in your IRA than in your taxable account.
Tax Loss Harvesting
Just as a fund manager will take a realized loss and match it with a realized gain in a mutual fund, a portfolio manager will do the same with index funds. Of the twelve distinct equity asset classes we employ, at least one of the asset classes produced a negative return of at least 5% in 44% of all six six-month time periods. This loss would be sufficient to sell the index fund, realize the loss, and replace it with a similar fund to maintain the asset allocation. The net effect of the transaction is a reduction in current or future tax liability without changing the financial characteristics of the portfolio.
Mutual Funds versus Separately Managed Accounts
Is it better to make equity investments using mutual funds or separately managed accounts? Each investment structure has advantages and disadvantages. Below is a review of the two methods.
Investors often believe they can implement an investment strategy of similar depth and breadth using a separate account as they can using a mutual fund. In many cases, spreading a single client's assets across the thousands of securities and multiple asset classes is not feasible or cost-effective. Due to their ability to use the pooled assets of shareholders to purchase and hold thousands of individual securities, mutual funds provide greater exposure to more securities across more asset classes. For example, due to the sheer number of individual securities required, a truly diversified allocation in international small companies or emerging markets companies is unlikely to be cost effective and may not be feasible in a separate account structure, except for accounts in excess of $250,000,000. Separately managed accounts can potentially work well for domestic core investments or international large cap core investments, but with many other asset classes, investment breadth can be severely limited.
An investor may believe a separately managed account can be sufficiently diversified by holding the securities of 50 different companies. Holding aside whether or not such an account is diversified enough even for one asset class, adding all the asset classes of a typical passive asset class mutual fund allocation to a separate account would require a substantially large investment - between $10-$500 million depending on the type and breadth of exposure the client is seeking.
Diversifying Low-Cost Concentrated Positions
While mutual funds provide the quickest diversification, a separate account can be more practical when an investor is slowly trying to unwind concentrated low-cost equity positions. Separate accounts can minimize capital gains exposure by matching gains from sales of the concentrated positions to harvested losses elsewhere within the account. The separately managed account is not attempting to invest in losing securities, but a diversified strategy will always present loss-harvesting opportunities. A key factor in the success of a loss harvesting strategy is whether a client can invest across enough securities to generate a level of realized losses that offset his or her projected gains.
Deductibility of Expenses
The tax deductibility of investment expenses makes mutual funds more favorable than separate accounts. Mutual funds are allowed to deduct investment expenses against the mutual fund's income prior to distributing that income. This results in the complete deductibility of investment expenses. Investment expenses of separate accounts flow through as a separately reportable item that an investor can potentially deduct on the itemized portion of his or her tax return. Unfortunately, the deductibility of these investment expenses is limited to the portion in excess of 2% of adjusted gross income. And if the separate account investor is subject to the alternative minimum tax, there is no deductibility for investment expenses.
In general, passively-managed asset class mutual funds are less costly than separate accounts offered by the brokerage industry. As assets in a separate account grow, the costs reduce. But when you consider that mutual funds can deduct their costs, the after-tax costs of passively managed asset class mutual funds are normally lower.
For charitable gifting, a broadly-diversified separate account allows an investor to select and donate securities that have appreciated the most. In general, the amount of appreciation will be the greater at an individual security level than at a mutual fund level. In a mutual fund the investor will still have the ability to donate appreciated shares, but the tax benefit will be less than in a separate account.
Capital Gains Legacy
For legacy planning, the timing of realized capital gains can be completely controlled in a separate account (with the exception of realized gains distributed to the investor due to corporate activity such as a merger). The realized gains are a direct function of the performance of the individual stocks.
In mutual funds, the realized capital gains are dictated by activities at the fund level. An investor can be affected by the behavior of other shareholders. The investor can experience capital gains distributions while experiencing a loss on their personal investment. The mutual fund investor loses control of the timing of taxable gains. To mitigate this, investors should employ passive tax-managed mutual funds that minimize capital gain distributions and taxable dividends.
Net Realized Capital Losses
The net realized capital losses from a separately-managed account, as previously discussed, can help the investor diversify low-cost positions through strategic loss harvesting. The capital losses can be used to offset gains that the investor might have in non-equity investments like real estate. If a mutual fund has a current year net realized capital loss, the capital loss can be carried forward seven years to offset realized capital gains in the future. The net realized capital losses can only offset gains realized by the mutual fund.
Investors normally do not associate tax-sensitive accounting with mutual funds. A big benefit to mutual funds comes from positive cash flows into the fund. With additional cash flows a mutual fund can have many different tax lots for a given stock. Disposals can therefore be handled in a more tax-efficient manner; realized gains are minimized by using high cost bases when selling a particular company's stock. If separate accounts do not have positive cash flows, there is less available in each position when choosing tax lots for sale.
Several other accounting methods unique to mutual funds can minimize the tax impact of large cash redemptions. If a mutual fund has large redemptions during the year, it can assign the realized capital gains resulting from the cash redemption via an accounting method called ?dividend equalization.? Dividend equalization assigns a portion of realized capital gains to the cash redemption, thus reducing the capital gains distributed at the end of the year to remaining shareholders.
Another sophisticated accounting method for minimizing tax is an ?in-kind redemption.? When a single shareholder makes a large redemption request, a mutual fund has the discretion to deliver a basket of the underlying equity securities owned by the fund instead of cash. The capital gains associated with the basket of securities are distributed to the redeeming mutual fund shareholders and the mutual fund will pick the lowest tax cost for the underlying securities to maximize the benefit of the in-kind redemption. Exchange traded funds commonly use this method of in-kind redemptions to flush out potential realized gains.
As a portfolio's investment characteristics cause its allocation to shift through time, new cash flows can be used to rebalance the strategy back towards its target. A mutual fund will generally have cash inflows that allow tax-free rebalancing. In a separate account, rebalancing can mean selling the securities that have appreciated in value and incurring hefty tax costs. Investors become ?locked in? to existing stocks just to avoid paying taxes. As the separate account matures, the amount of security turnover declines significantly unless the investor is willing to incur tax cost to rebalance. An unfortunate consequence is that the separate account will become more concentrated in fewer securities and therefore become riskier over time.
Both mutual funds and separately-managed accounts have advantages and disadvantages for the taxable investor. An investor should recognize that mutual funds engineered for tax-sensitive investors are competitive with separately-managed accounts. Ultimately, the individual circumstances of the investor determine which investment vehicle is most appropriate.