Key Takeaways
Don’t underestimate how much of your investment gains you’re giving up in taxes. That money can’t compound when it’s in Uncle Sam’s hands.
Most active investment managers consistently underperform the market—and that’s before factoring in fees and the extra taxes their active trading triggers for shareholders.
There are ways to control how much of your money is in tax-inefficient assets and how much you’re paying in gains as a result of your active manager’s portfolio turnover.
Investing is a complicated matter, unless you believe the E-Trade ads, it’s so easy a baby can do it. If it is so easy, why do the majority of money managers underperform their respective benchmarks? Research from S&P Dow Jones Indices shows that nine out of ten active investment managers have underperformed the unmanaged S&P 500 index over the past 10 years—and taxes on capital gains and distributions are not factored in for their “active” trading. Most investment managers don’t care about the net after-tax return. But you should, since all those bites taken out of your total return can’t be compounding over time. If nothing else, you want to control the things you can control by implementing a tax-efficient investment strategy.
I know it may be painful, but as you review your tax return, take a moment to evaluate Schedule B, Schedule D, and Form 8949. Schedule B captures all your dividends. Schedule D captures capital gains and losses from your sales of assets. Form 8949 details the capital gains and losses from your investments.
Many financial institutions issue these forms as an afterthought, i.e., the “cost of doing business” as an investor. However, I urge you to look closer at how much of your hard-earned money you’re giving back to Uncle Sam because of your manager’s excessive trading, portfolio turnover, poor asset placement, or capital gain distributions.
Most portfolio managers just want you to focus on the returns they’re generating for you; they don’t want to talk about net after-tax returns. They’re not incented to mitigate the tax hit you take by investing with them. They also tend to ignore other techniques to improve your net after-tax returns, such as advising on (and implementing) asset location preferences.
Tax Efficient Investing
Let’s say you have $2 million -- $1 million in an IRA and $1 million in a taxable account. Most institutions will invest the accounts entirely independently. Some managers don’t even consider the account type when investing. This is very important, so we take it a step further. We invest the entire $2 million, taking into consideration both account types and their tax differences. We are able to keep the assets in their respective vehicles but invest as though all the funds are in one account.
We label each asset as either “tax advantageous” or “tax inefficient.” The tax-inefficient assets are things like real estate, Treasury bonds, corporate bonds, TIPS, or small cap funds with high turnover. These investments would typically fill up your IRA account. If you’re a high earner and not paying attention to how much of your portfolio is tilted toward tax-inefficient assets, then you could be paying 37% (federal) tax on the income those investments throw off, plus your state taxes, which could be at the 6% to 11% rate if you’re a New Jersey resident. That’s nearly half of your money going being taxed away in seemingly “safe” investments.
But that’s not what most advisors will tell you. Instead, they’ll exclaim: “Wow, you got a 15% return last year.” But you really kissed half of that 15% away because you didn’t properly diversify the tax exposure of that income.
Instead, we can help you maintain the risk exposure you are comfortable with while investing the tax-inefficient assets in an account that will minimize the amount of tax you pay until must sell some of the assets, likely not until retirement. Meanwhile, we can put your tax-efficient assets, such as municipal bonds, U.S. stocks, and international core into the taxable side of the ledger. This strategy does not involve using annuities (another cautionary conversation entirely). These are regular brokerage and IRA accounts.
That’s why it’s worth looking at Schedule B, Schedule D, and Form 8949 to see if you had to write Uncle Sam a big check due to the growth in your accounts. If so, just know your accounts can be managed better to achieve healthy returns with lower tax exposure.
In addition to asset placement, watch out for mutual funds that buy and sell lots of holdings during the year. The more “portfolio turnover” they have, the more capital gain distributions they generate for the fund – and they must pass those distributions on to their shareholders, i.e., you. Even more troublesome with high turnover funds is that they can also generate lots of short-term gains (i.e., held less than one year) as they tidy up their positions before year-end. So, you must pay tax at your ordinary income rate, not the capital gains rate. This could add between 17% and 22% tax to your gains. Why pay those extra taxes? With prudent planning, you won’t have to. “I can’t control what the fund manager does,” you may be thinking to yourself. Well, you do have some control. You can find funds that make a conscious effort to reduce portfolio turnover. You can also use exchange-traded funds (ETFs) if appropriate. And if you have a large enough portfolio, you can use a managed account (aka “personal index”), which is essentially your own diversified mutual fund. Managed accounts let you control the amount of capital gain you are willing to take in any given year based on how much tax you want to pay that year.
Restrictions On Loss Carry Forwards Many of you are familiar with tax-loss harvesting in which you can use losses from underperforming investments to offset gains from well-performing investments. Just know that you cannot use more than $3,000 in losses per year to deduct against your taxable income. And if you're a New York or New Jersey resident, you are not permitted to carry forward any excess losses above $3,000 into future years for your state income tax returns.
Capital Gain Harvesting
Most investors assume the long-term capital gains rate is 15% and that’s the default percentage most investment firms use in their case studies and examples. But high earners with adjusted gross income (AGI) above $492,300($553,850 if married and filing jointly) pay 20% on long-term gains. Meanwhile, if you are recently retired, or had a significant job loss or other life circumstance that temporarily reduced your income, now might be a good time to prune your portfolio and reduce some of your long-held positions. That’s because married couples with AGI below $89,250, pay 0% in capital gains.
Personalization
How well does your advisor know you and your personal financial situation? If you’re just another account at a large broker-dealer, don’t expect much help. But if you’re with an advisor who knows your situation well, they can advise you about how much you can afford to take in gains in a particular year and how much you can take in losses to optimize your tax situation.
By the way, loss-harvesting and capital gains management is something you and your advisors should be doing all year round; it’s not just a year-end exercise. Tax management is important, but goal planning and proper diversification are more important. Paying taxes is a necessary evil, but choosing how you maximize your wealth is something you can control. As the old saying goes: “Don’t let the tax tail wag the dog.”
Real-World Example
We’re working with a Fortune 500 executive who earns over $1 million a year. If we’re not mindful of taxes, she’ll be forking over 30% of her long-term capital gains to Uncle Sam (federal and state). If her portfolio is not properly designed, she could be looking at 47% tax (federal and state) for short-term gains and fixed income. That’s not only a big tax hit every year, but a huge chunk was taken out of her portfolio that can’t grow over time via the power of compounding.
It's nice to brag to your friends that your star manager generated a 14% return for you. But if that manager was constantly turning over the portfolio to eke out the best returns, you may have only earned about 8% after taxes. Wouldn’t you rather have a 10% return and only give back 1% in taxes? Sadly, they don’t give “Manager of the Year” awards for after-tax returns.
Conclusion
We can’t control the markets, but we can control what we pay in taxes. If you or someone close to you has concerns about your portfolio or tax outcome, contact us any time to discuss. We’re happy to help.
ROBERT B. DUNN, CFP® is the President and Managing Partner of Novi Wealth