With the April 15th filing deadline behind us, it's natural to want to put tax issues to rest. However, with the sting of taxes still fresh in our minds, it's a good time to review investment portfolios for tax efficiency.
Taxes and investment expenses are two areas over which we investors have direct control, and both can have a significant impact on investment performance. A smart approach and proper planning with regard to taxes will maximize net returns and avoid unpleasant surprises at tax time.
Income vs. Gains
The first step is to understand the tax implications for investments. The two basic ways investments are taxed is as current income or as capital gains. Unfortunately, the distinction between these two categories gets a little muddy.
Capital gains are the profits earned from buying and selling assets. Those assets held for more than a year are considered "long-term" holdings, meaning any gain from a sale is taxed at a more favorable rate. Most dividends paid by common and preferred stock of U.S. corporations are considered "qualified" and also receive this favorable tax treatment. The current top federal tax rate for long-term capital gains on investment assets is 20% - substantially lower than the rate on current income.
Interest from savings accounts and (most) bonds, on the other hand, is taxed as current income. This means it is lumped in with salary and subject to ordinary income tax rates. Distributions from real estate investment trusts (REITs) also fall into the current income category, as do "short-term" gains from the sale of an asset held for under a year. The top federal tax rate for current income now stands at 39.6%, nearly twice the long-term capital gains rate.
To further cloud the "income versus gain" distinction, interest paid on many (but not all) bonds issued by state and local municipalities are exempt from federal taxation.
Being tax efficient starts with the assets you own and where you hold them.
"Asset location" is the strategy of matching investments to the appropriate account - taxable, tax-deferred or tax-free. Investments generating high current income and taxable gains should be held in tax-deferred or tax-free accounts (IRAs, Roth IRAs and 401k plans), while taxable accounts should contain more tax-friendly holdings such as stocks, tax-free municipal bonds and tax-managed mutual funds.
One key to this approach is viewing the portfolio as a whole rather than by account. You can, and should, expect various account types to perform differently based on the holdings, keeping in mind that it's the bottom-line return of the portfolio that matters. A taxable account that performs better than an IRA (or vice versa) is of no consequence, as long as the overall asset allocation is appropriate and tax efficiency is maximized.
Since investments vary greatly in terms of their impact on your taxes, it's important to know their relative tax friendliness. This, of course, is often not cut and dried, but a general understanding of tax efficiency is needed to determine which assets should be held in which accounts.
Bonds, and particularly high yield or "junk" bonds, are among the least tax efficient investments since they generate high levels of current income. REITs and REIT funds also fall into the inefficient category. These are prime candidates for filling your tax-advantaged accounts (e.g. IRA, 401k) first.
Balanced funds (with a significant allocation to bonds) and actively managed stock funds are modestly better on the tax front, but still tend to generate high taxable payouts. These are the next-best candidates for tax-deferred accounts.
Tax-exempt municipal bonds would be very suitable for a taxable account, as would individual stocks held for the long-term. Stock index funds and exchange-traded funds also tend to be good choices for a taxable account, as distributions are generally modest and taxed at the lower capital gains rate.
A category of mutual fund known as "tax-managed funds" is also designed specifically for taxable accounts. These funds use strategies focused on reducing taxable distributions to make them even more tax friendly.
Areas of caution
For actively-managed stock funds, capital gains will come in two flavors: the gains generated by a sale you (as the shareholder) make, and gains generated by activity within the fund (i.e. out of your control). The fund manager's actions can determine capital gains distributions for any given year, and those distributions could result in a painful tax bite - even in a down year. If you choose to own actively-managed funds, it is generally better to hold them in tax advantaged accounts.
Another consideration when buying a mutual fund for a taxable account is the level of "undistributed gains" within the fund. This can take a bit of work to uncover, but a fund data service such as Morningstar� will generally provide this information. These are gains that already exist within the fund and could be distributed to you in the future (whether or not the gains actually accrued to you).
An often overlooked area of tax efficiency is the management of gains within a taxable account.
Tax-loss harvesting is the practice of selling investments that have declined in value to offset other current (or future) capital gains. Since losses can be used to offset gains when reporting your taxes, this can be an effective way to reduce your investment tax bill. It's important to note that the proceeds from a loss sale cannot be reinvested in a substantially identical security within 30 days, or the loss may be disallowed under IRS "wash sale" rules. Unfortunately, the interpretation of what is "substantially identical" is left up to the IRS, but there are a number of ways to effectively reinvest the money in a similar asset class or category without any problem.
Worth the trouble
Good tax efficiency takes some research, diligence and know-how to be effective, but the financial rewards are clear. Remember, it's not just what your investments earn, it's what you ultimately keep that matters.