Get Efficient! Do More With Less (Earn More With Less Tax)

Do you think about taxes before you make investments?  You should.  Controlling your tax bill is easier when you think about taxes before you “buy”.  What I’m talking about is tax efficient investing.  Today, I’m going to discuss a basic level of tax efficient investing…selecting tax-efficient Mutual Funds and ETFs.

When you look at a Mutual Fund’s (or ETF’s) advertising materials you will normally see the fund’s returns.  You will see the same or similar numbers on many “independent” fund ranking sites.  But, what you’re not seeing is the after-tax return and the difference can be significant.

The reason comes down to how the fund earns its money.  If a fund is actively managed, then normally there are more transactions and because of those transactions capital gains are recognized throughout the year.  The capital gains will be distributed to the mutual fund shareholders in December and those distributions are taxable (assuming the funds are held in a taxable account).  On the other hand, a passive/index fund will not have as many transactions and have lower capital gains to distribute in December.

So let’s take a look at a couple of examples.  I’m not recommending any of these funds, but have selected them only to illustrate the point.  We’ll look at some funds using on-year return as a determining factor (again, not recommending that you use one-year return as a determining factor but some do).  Two asset classes that are illustrative are Large-Cap Blend and Small-Cap Value.

• Large Cap (Name of Fund/Return)
  • Dreyfus Large Cap Equity Fund/27.36%
  • Schwab US Large Cap ETF/24.77%
• Small Cap Value (Name of Fund/Return)
  • Hotchkis & Wiley Small Cap Value Fund/32.06%
  • Vanguard Small Cap Value ETF/28.23%

Using the returns above, you might be tempted to select the fund listed first.  If you’re putting these funds in a taxable account, that might be a mistake.  Let’s look at the same funds’ after-tax return (after tax returns are based on the highest tax bracket).

• Large Cap (Name of Fund/After-tax Return)
  • Dreyfus Large Cap Equity Fund/19.89%
  • Schwab US Large Cap ETF/23.77%
• Small Cap Value (Name of Fund/After-tax Return)
  • Hotchkis & Wiley Small Cap Value Fund/22.04%
  • Vanguard Small Cap Value ETF/27.20%

In both cases, the higher earning fund distributed more earnings (due to portfolio turnover) in December and as a consequence of the resulting taxes, their returns were reduced by almost 1/3 to below the after-tax return of the index ETFs.

What can you do about it?  First ask your advisor if he/she considers tax efficiency when he/she builds your portfolio.  If not, ask why and then ask yourself why he/she is your advisor.  If you don’t have an advisor and don’t want one, information of funds’ tax efficiency is available through Morningstar.

Tax efficiency matters.  There is a concept called “Tax Alpha” which basically describes the additional return that can be achieved through tax-efficient investing.  Some studies put “Tax Alpha” at around 1-2%.  Something to think about…

Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.

 

But Wait! There’s More! Tax-Efficient Investing

In my last post, I talked about how a non-deductible Traditional IRA can be an effective tool to minimize taxes especially when the assets in the IRA “throw-off” a significant amount of income and the income is taxed at your marginal rate.  What if that isn’t the case?  Well…that is the topic for this post.  What if you were to deposit your Large-Cap Stock Funds into a Traditional IRA?  Let’s take a look.

First the assumptions that I’ll use.

• We will use the average return of the S&P 500 from 1950 – 2009
  • The total return is 11%
  • 3.6% of the total return is from dividends
• The dividends are “Qualified” so they are taxed at 15% (current tax code)
• The marginal tax rate throughout the scenarios is 25%
• IRA distributions are taxed at the marginal rate
• For this illustration ObamaCare Surtaxes are ignored

In the first scenario, you can contribute $5,500 to a tax-deductible Traditional IRA or $4,125 ($5,500 – $5,500 x 25%) to a taxable account.  So which one wins?  The ability to contribute pre-tax dollars to the Traditional IRA outweighs the lower tax rate paid on the investments in the taxable account every year.  After 30 years the after-tax account values are …

• Deductible IRA:      $911,266
• Taxable Account:    $800,278

So the Deductible IRA puts more money in your pocket.

In the second scenario, you can contribute $5,500 to a non-deductible Traditional IRA or $5,500 to a taxable account.  In this case, even though you pay taxes on the dividends as they are paid, the taxable account is worth more than the non-deductible Traditional IRA each year.  After 30 years the after-tax account values look like this…

• Non-Deductible IRA:  $952,517 (higher than above because the IRA has “basis”)
• Taxable Account:  $1,067,038

So, the bottom line?  As the Weapons School Instructors used to say, “It depends”.  Think about what tax strategy will put the most money in your pocket before you allocate your assets to separate accounts or get someone who can help you figure it out for you.

Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.

He specializes in assisting transitioning Senior Military Officers reach their financial goals.