Tax Efficient Investing, Part II

| May 2, 2013 | 0 Comments

Last month I wrote about different types of investment earnings, including taxable and tax-exempt income and capital gains. This month I’ll discuss how investors can go about creating portfolios that take advantage of these characteristics.

Given the different types of earnings from investments, it should be clear that each will have a different impact both on your total return and on your tax bill. Total return includes all income and capital appreciation, so for most investors, maximizing after-tax total return is paramount. After all, having $1,000 left over after taxes is better than having only $500 that you owe no taxes on, isn’t it? Following are some considerations we use in portfolio construction to try to maximize your after-tax return.

Taxable vs. Non-Taxable Income. The higher your income tax rate, the more attractive municipal bond income becomes. While municipal bond income is tax-exempt, their yields are so low that investors in lower tax brackets can generally do better by purchasing taxable bonds and paying taxes on the higher income.

Capital Gain Distributions. Some stock mutual funds are more efficient than others. There are many reasons for this, from the investment strategy the managers follow to whether or not tax considerations are even a part of the fund’s investment process. Turnover (how often trades are placed in the portfolio) is often used as a rough proxy for tax efficiency, but it’s not a very good one.

Investors need to be aware of the manager’s propensity for generating capital gain distributions, which create taxable income for investors, and whether they are typically long-term or short-term gains. For example, some funds using complex investment strategies involving options trading will often distribute a pre-determined mix of income and capital gains, which allows investors to better plan their purchases of these investments.

Generally speaking, mutual funds and exchange traded funds which track indexes tend have fewer changes in the underlying portfolio. This reduced trading often makes them more tax efficient than other actively managed funds and reduces the potential for taxable distributions.

Trading. While portfolio turnover isn’t a great proxy for tax efficiency, it can be an indicator because every trade creates an opportunity not only for higher costs, but for realization of gains and thus generation of taxable income. It also allows managers to sell investments at a loss in order to offset investments being sold for a gain. This is one strategy that fund managers may employ.

Asset Location Matters. Some investment accounts are taxable, such as most trust accounts, savings and checking accounts and ‘ordinary’ brokerage or mutual fund accounts. On the other hand, some account types are designed to encourage people to save for retirement, like 401(k), 403(b), IRA and Keogh accounts.

Retirement accounts are almost always considered tax-deferred; you usually get a tax break up front and the earnings on those savings won’t be taxed until you take the money out later. An exception is a Roth account, where you don’t get the initial tax break up front, but the earnings are never taxed, even once they are withdrawn later.

With a taxable account, earnings may be taxed every year, leaving less money in the account to grow over time. All else being equal, a tax-deferred account should outperform a taxable account over the long-run because of the annual drag created by paying taxes on the earnings.

For these reasons, investors often favor putting higher tax investments like bonds or hedge funds into tax deferred accounts. Other investments which may be taxed at lower rates (like stocks which can generate dividends and capital gains) would be purchased in taxable accounts. High income taxpayers will need to consider using tax-free municipal bonds for fixed income allocations in taxable accounts. Investors should consider both their needs for liquidity as well as the potential after-tax returns on investments as they decide where to purchase a given investment.

This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at Rick and his family live in Mission Hills.

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