Boost Your After-Tax Investment Returns
You can extend the life of your nest egg by carefully managing the tax bite on your portfolio.
Tax season is just about over. You've trimmed your tax tab by taking as many tax write-offs as you could. Warning: Your job is not over yet.
When it comes to minimizing your tax bill, your annual tax return is just a short-term tactic. You can save more money over the long term if you engage in strategies to boost your after-tax investment returns. "Taxes are the biggest drag on returns," says Rande Spiegelman, vice-president of financial planning at Charles Schwab.
You can't eliminate all investment-related taxes, of course, but studies show that you can extend the life of your retirement nest egg by improving the "tax efficiency" of your investing.
It's a strategy that many investors overlook, says David Blanchett, the head of retirement research at Morningstar. "It's easy for an investor to figure out whether a mutual fund outperformed an index," he says. "But most people don't think about how taxes affect their long-term portfolio." And like limiting investment fees, managing the tax bite is one of the few areas that you can control. "It's almost a free lunch," he says.
The strategy is based on the fact that different kinds of investments are taxed differently. Also, earnings from the same investment are taxed differently depending on whether it is in a taxable brokerage account, tax-deferred IRA or 401(k), or tax-free Roth. The goal is to put the right investments in the right accounts to maximize after-tax returns. The order in which you withdraw from the various accounts also helps or hurts your overall results.
The most basic rule of thumb is to place stocks in a taxable account and bonds in your IRA. (We'll get to the intricacies and the exceptions later.) During retirement, you withdraw from accounts in this order: taxable, traditional IRA and Roth.
To demonstrate the advantage of tax-efficient investing, Blanchett and Morningstar colleague Paul Kaplan created nine hypothetical portfolios, all with an allocation of 40% stocks and 60% bonds—a reasonable allocation for someone approaching or in the early years of retirement. The account balances for a 401(k) and taxable account were equal. At one end of the spectrum, an investor pursued a rule-of thumb strategy—placing the stocks in the taxable account and most of the bonds in the 401(k), and then tapping the taxable account before withdrawing from the 401(k). With an inefficient portfolio, the 401(k) held stocks, and the investor withdrew from the retirement account first. In a "split" portfolio, stocks and bonds were placed equally in both accounts, which were tapped simultaneously.
The tax-efficient portfolio generated 3.23% more in after-tax annual income during retirement than the split portfolio, the researchers found. Blanchett used the split portfolio to compare with the "efficient portfolio" because he assumed that typical investors would more likely spread different types of investments and income across accounts—but not tax efficiently.
A big caveat: You should not worry about tax efficiency if nearly all of your money is in a tax-favored IRA or 401(k). The objective of employing strategies to boost tax-efficiency is to reduce taxes generated in your taxable account. If, say, 90% of your retirement stash is in tax-deferred accounts, place the most-efficient 10% of your assets in the taxable account and don't worry about the rest. And don't skimp on stowing away money into your retirement account in order to play the tax-efficiency game. Place as much money as you're allowed in your IRA or 401(k), where your investments will grow tax deferred for years.
First choose a well-diversified portfolio based on solid investments and your risk tolerance. Then you can play the tax-efficiency card to the extent possible based on your specific situation. "You hear a lot of people saying, 'Never let the tax tail wag the dog,' " says Tom Roseen, head of research services at investment research firm Lipper. That's true, he says, but, "on the flip side, if you're surrendering two percentage points a year to Uncle Sam, keeping a good eye on after-tax returns and on asset location is hugely important."
Even a "seemingly small tax drag" can have a big impact on an investment's long-term growth, Roseen says. To illustrate, he looked at the before- and after-tax performance of taxable fixed-income funds for the ten years that ended December 31, 2012. The before-tax annual performance averaged 5.44% a year.
If $10,000 of fixed-income investments had been placed in an IRA at an annual return averaging 5.44% a year, the investment would have grown to $48,933 after 30 years. If the same investments had been placed in a taxable account, Roseen figures that taxes on capital gains and other distributions would have consumed 1.76 percentage points—for an average after-tax performance of 3.67% a year. After 30 years, the taxable account would have held $29,527.
How much of the IRA's apparent advantage would be lost to taxes upon withdrawal would depend on the investor's marginal tax rate. If the investor's tax rate is 25%, the IRA would still be more than $7,000 ahead after the full $48,933 was withdrawn.
You can get even more flexibility if you open a Roth IRA. You can convert part of your traditional IRA or, if you're still working, funnel money into a Roth 401(k). If you choose the conversion route, take care that the income from the switch does not bump you into a higher tax bracket. And opening a Roth may only make sense if you expect to be in the same or a higher tax bracket down the road.
Location, Location, Location
Once you settle on asset allocation, turn your attention to asset location. To the extent possible, figure out which holdings are most tax-efficient and most tax-inefficient. It's the least-efficient ones that should go into a tax-sheltered account.
Facing new, higher rates on ordinary income and capital gains, wealthier taxpayers have the most to gain by pursuing a tax-efficient investment strategy, says Maria Bruno, a senior investment analyst at Vanguard. "When tax rates rise on individuals with higher income, or when you're in a higher bracket, asset location is all the more important because of how the accounts are taxed," Bruno says.
With a taxable account, you pay ordinary income tax of up to 39.6% on interest payments and up to 20% on qualified dividends and long-term capital gains. Higher-income investors also now pay a new 3.8% surtax on certain investment income. With a traditional IRA, you pay ordinary income tax on all withdrawals (assuming you've made no nondeductible contributions), while all withdrawals from a Roth are tax free.
A brokerage account is the best place to hold any tax-exempt municipal bonds you own—why waste the tax break in a tax-favored IRA? (And muni-bond interest earned inside an IRA will be fully taxed when it's withdrawn.) Assuming you have room, perhaps your taxable account will include a large-company index fund that you intend to hold for a long time—you pay the tax-favored capital-gains tax on profits and you'll incur most of that only when you sell. Holding stocks in an IRA converts those long-term gains into ordinary income, which is taxed at a higher rate when you withdraw. Stash living-expense money in a bank account, or Bruno suggests, use tax-exempt municipal money-market funds for your short-term needs.
Place investments that generate the most taxable income in a traditional IRA. This includes real estate investment trusts and most taxable bonds and bond funds, especially high-yield bonds and inflation-protected securities. Interest on these assets—and inflation adjustments in the case of inflation-protected securities—would be taxed at ordinary income-tax rates each year if they were held in a taxable account. "They kick out a lot of annual income," Bruno says. Individual stocks that you intend to hold less than a year also may be better off in an IRA; in a taxable account, you would pay short-term capital-gains taxes, at your ordinary income-tax rate, if you sell within a year. You'll pay ordinary income rates on the money when it comes out of the IRA, too, but you'll enjoy tax-deferred compounding until that time.
The rules of thumb—stocks in taxable accounts and bonds in tax-favored accounts—don't always apply. For mutual funds, you need to consider the "turnover rate." Even if you lose money on a fund, you'll pay long- and short-term capital-gains tax on distributions each year if the fund is held in a taxable account. That occurs when a fund manager sells—or turns over—holdings for more than their purchase price. You also will pay tax on interest on any bonds held in a fund.
Index funds and exchange-traded funds that follow a broad benchmark, such as a fund that tracks Standard & Poor's 500-stock index or a broad international-fund index, have low turnover rates. Trading in these funds is limited so they generate little in capital gains and the dividends tend to be low. The relatively low annual tax liability makes such funds better candidates for a taxable account than a tax shelter. Actively managed funds tend to have higher turnover "so they probably should go to the tax shelter," Roseen says.
But not all index funds cry out to be in a taxable account. Some narrower index funds and ETFs, such as those that follow a sector or an individual country, may have considerable turnover and could be better off in an IRA. Small-company stock index funds also tend to be inefficient because fund managers may need to buy and sell holdings more often. And bond index funds tend to generate taxable distributions.
To check the fund's turnover rate, go to Morningstar.com, plug in the fund's symbol, and click on the "Tax" tab. The Vanguard 500 Index fund, for instance, has 3% turnover, which means it tends to hold stocks indefinitely. Many actively managed funds that invest in large U.S. companies have turnover rates of 50% or more, meaning that half of the stocks are sold and replaced within a year. Compare a fund's turnover rate to those of its peers.
Also look at the fund's performance, particularly its tax-adjusted return. Lipper, which is owned by Thomson Reuters, a business information company, offers two tools to help you judge a fund's after-tax return and its tax efficiency. Go to www.reuters.com, place your cursor on the "Money" tab, and click "Fund Screener" from the menu. At the bottom of the page (at "view overview page for"), plug in the fund's symbol or name.
By clicking on "Lipper Leader Ratings," you can see the fund's tax-efficiency rating—5 is the best. By clicking on the "Performance" tab, take a look at "after-tax preliquidation" and how it compares with the "SEC performance." The difference is the amount of the return you will pay per share in taxes on capital gains, dividends and interest income.
These measures can help you figure out the best home for a particular fund or choose a fund for a taxable account. If you're looking at two funds with the same returns, Roseen says, "but one is more tax efficient than the other, that is the fund I would choose for a taxable account."
The asset's returns also could be as important as the tax rate in deciding where to place an asset. Generally, for example, Roth accounts should hold investments with the potential for the highest return, such as growth stock funds. In a Roth, you don't need to take minimum distributions and investments grow tax free.
Michael Kitces, director of research at Pinnacle Advisory Group, in Columbia, Md., believes location matters more for high-return investments than for low-return assets. The goal of placing assets inside a retirement account "is to take advantage of tax-deferred compounding returns," he says. If returns are low, he says, "there simply isn't much to compound in the first place." That's the case for many bonds, particularly low-yielding government bonds.
Kitces says that with bond interest rates so low it may not matter where you place the bonds if you have other tax-inefficient assets that have higher returns—and you have a small IRA. The idea is to set priorities for placing your most inefficient and efficient assets.
He offers this example: Say you have a $90,000 taxable account and a $10,000 IRA. Your investments are split equally among bonds; cash; a high-turnover, high-return stock fund; and a high-return index fund. The first priority would be to put the most inefficient asset—$10,000 of the stock fund—into the IRA. The bonds would go into the taxable account, Kitces says, "not because we prioritized them there, but because we prioritized something else in the IRA first."
Your priorities would change if you had a $10,000 taxable account and a $90,000 IRA. Your most-efficient asset—$10,000 of the index fund—would go into the taxable account, "where it benefits most," Kitces says. The rest would go into the IRA.
Beyond choosing the best account for each investment, other moves can hold down Uncle Sam's take of your investment profits. If you're about to sell a stock in a taxable account, Spiegelman says, pay attention to the holding period. If you bought it nearly 12 months ago, hold on to it a year and a day, to avoid the short-term capital-gains tax. But if you'd have to wait six months to move into long-term gain territory, go ahead and sell, he says. It's better to pay the taxman than risk a loss in the market.
When you rebalance your portfolio, do as much as possible inside your IRA, where transactions have no tax consequence. For example, if your stock portfolio is now above your target allocation relative to bonds, Spiegelman says, "the first place to go is your tax-advantaged accounts. You can sell some stocks without incurring taxable capital gains."