Strategies to Minimize Taxes
Keeping More of Your Investment Returns
By Timothy F. Bock
November 2005
You may have heard a common investment expression “It’s not what you make that counts. It’s what you keep.” Minimizing taxes from investment activities is important because it’s one of the few aspects of investing that an investor can gain virtually total control over. Paying attention to the tax consequences of investing can substantially increase long-term wealth and increase spendable income. This article will address various investment strategies and products for minimizing taxes.
Equities Placement
Stocks should be held (owned) to the extent possible in taxable accounts. This is due to four reasons; Stocks are taxed on dividends and realized capital gains only, whereas if the same stock or equity fund is held in an IRA, upon distribution, the total return is fully taxable. Second, the tax rates applied to dividends and capital gains are lower than the ordinary income tax rate associated with withdrawals from tax-deferred accounts. Third, upon death, there is a step up in basis on stocks, eliminating the capital gain liability. This is not available if stocks are owned in tax-deferred accounts. Fourth, there is an opportunity, in taxable accounts, to use tax loss harvesting to further reduce capital gains tax liability. This isn’t available in tax-deferred accounts.
Fund Placement
Even among index funds, some are more tax-efficient than others. If an asset allocation involves placing a portion of the equity allocation in a tax-deferred account, the least tax-efficient funds should be placed there first; For example, REITS, or an international small value fund (for which there are no tax-managed funds), are better served in your IRA than in your taxable account.
Tax Loss Harvesting
Just as a fund manager will take a realized loss and match it with a realized gain in a mutual fund, a portfolio manager will do the same with index funds. Of the twelve distinct equity asset classes we employ, at least one of the asset classes produced a negative return of at least 5% in 44% of all six six-month time periods. This loss would be sufficient to sell the index fund, realize the loss, and replace it with a similar fund to maintain the asset allocation. The net effect of the transaction is a reduction in current or future tax liability without changing the financial characteristics of the portfolio.
Mutual Funds versus Separately Managed Accounts
Is it better to make equity investments using mutual funds or separately managed accounts? Each investment structure has advantages and disadvantages. Below is a review of the two methods.
Investment Breadth
Investors often believe they can implement an investment strategy of similar depth and breadth using a separate account as they can using a mutual fund. In many cases, spreading a single client’s assets across the thousands of securities and multiple asset classes is not feasible or cost-effective. Due to their ability to use the pooled assets of shareholders to purchase and hold thousands of individual securities, mutual funds provide greater exposure to more securities across more asset classes. For example, due to the sheer number of individual securities required, a truly diversified allocation in international small companies or emerging markets companies is unlikely to be cost effective and may not be feasible in a separate account structure, except for accounts in excess of $250,000,000. Separately managed accounts can potentially work well for domestic core investments or international large cap core investments, but with many other asset classes, investment breadth can be severely limited.
An investor may believe a separately managed account can be sufficiently diversified by holding the securities of 50 different companies. Holding aside whether or not such an account is diversified enough even for one asset class, adding all the asset classes of a typical passive asset class mutual fund allocation to a separate account would require a substantially large investment - between $10-$500 million depending on the type and breadth of exposure the client is seeking.
Diversifying Low-Cost Concentrated Positions
While mutual funds provide the quickest diversification, a separate account can be more practical when an investor is slowly trying to unwind concentrated low-cost equity positions. Separate accounts can minimize capital gains exposure by matching gains from sales of the concentrated positions to harvested losses elsewhere within the account. The separately managed account is not attempting to invest in losing securities, but a diversified strategy will always present loss-harvesting opportunities. A key factor in the success of a loss harvesting strategy is whether a client can invest across enough securities to generate a level of realized losses that offset his or her projected gains.
Deductibility of Expenses
The tax deductibility of investment expenses makes mutual funds more favorable than separate accounts. Mutual funds are allowed to deduct investment expenses against the mutual fund’s income prior to distributing that income. This results in the complete deductibility of investment expenses. Investment expenses of separate accounts flow through as a separately reportable item that an investor can potentially deduct on the itemized portion of his or her tax return. Unfortunately, the deductibility of these investment expenses is limited to the portion in excess of 2% of adjusted gross income. And if the separate account investor is subject to the alternative minimum tax, there is no deductibility for investment expenses.
Costs
In general, passively-managed asset class mutual funds are less costly than separate accounts offered by the brokerage industry. As assets in a separate account grow, the costs reduce. But when you consider that mutual funds can deduct their costs, the after-tax costs of passively managed asset class mutual funds are normally lower.
Charitable Gifting
For charitable gifting, a broadly-diversified separate account allows an investor to select and donate securities that have appreciated the most. In general, the amount of appreciation will be the greater at an individual security level than at a mutual fund level. In a mutual fund the investor will still have the ability to donate appreciated shares, but the tax benefit will be less than in a separate account.
Capital Gains Legacy
For legacy planning, the timing of realized capital gains can be completely controlled in a separate account (with the exception of realized gains distributed to the investor due to corporate activity such as a merger). The realized gains are a direct function of the performance of the individual stocks.
In mutual funds, the realized capital gains are dictated by activities at the fund level. An investor can be affected by the behavior of other shareholders. The investor can experience capital gains distributions while experiencing a loss on their personal investment. The mutual fund investor loses control of the timing of taxable gains. To mitigate this, investors should employ passive tax-managed mutual funds that minimize capital gain distributions and taxable dividends.
Net Realized Capital Losses
The net realized capital losses from a separately-managed account, as previously discussed, can help the investor diversify low-cost positions through strategic loss harvesting. The capital losses can be used to offset gains that the investor might have in non-equity investments like real estate. If a mutual fund has a current year net realized capital loss, the capital loss can be carried forward seven years to offset realized capital gains in the future. The net realized capital losses can only offset gains realized by the mutual fund.
Tax-Sensitive Accounting
Investors normally do not associate tax-sensitive accounting with mutual funds. A big benefit to mutual funds comes from positive cash flows into the fund. With additional cash flows a mutual fund can have many different tax lots for a given stock. Disposals can therefore be handled in a more tax-efficient manner; realized gains are minimized by using high cost bases when selling a particular company’s stock. If separate accounts do not have positive cash flows, there is less available in each position when choosing tax lots for sale.
Several other accounting methods unique to mutual funds can minimize the tax impact of large cash redemptions. If a mutual fund has large redemptions during the year, it can assign the realized capital gains resulting from the cash redemption via an accounting method called “dividend equalization.” Dividend equalization assigns a portion of realized capital gains to the cash redemption, thus reducing the capital gains distributed at the end of the year to remaining shareholders.
Another sophisticated accounting method for minimizing tax is an “in-kind redemption.” When a single shareholder makes a large redemption request, a mutual fund has the discretion to deliver a basket of the underlying equity securities owned by the fund instead of cash. The capital gains associated with the basket of securities are distributed to the redeeming mutual fund shareholders and the mutual fund will pick the lowest tax cost for the underlying securities to maximize the benefit of the in-kind redemption. Exchange traded funds commonly use this method of in-kind redemptions to flush out potential realized gains.
Rebalancing
As a portfolio’s investment characteristics cause its allocation to shift through time, new cash flows can be used to rebalance the strategy back towards its target. A mutual fund will generally have cash inflows that allow tax-free rebalancing. In a separate account, rebalancing can mean selling the securities that have appreciated in value and incurring hefty tax costs. Investors become “locked in” to existing stocks just to avoid paying taxes. As the separate account matures, the amount of security turnover declines significantly unless the investor is willing to incur tax cost to rebalance. An unfortunate consequence is that the separate account will become more concentrated in fewer securities and therefore become riskier over time.
Conclusion
Both mutual funds and separately-managed accounts have advantages and disadvantages for the taxable investor. An investor should recognize that mutual funds engineered for tax-sensitive investors are competitive with separately-managed accounts. Ultimately, the individual circumstances of the investor determine which investment vehicle is most appropriate.
Municipal Bonds
The tax-free income from municipal bonds can provide higher after-tax returns compared to corporate or treasury bonds for investors in higher tax brackets. For investors in the federal marginal tax bracket of 28% or higher, municipal bonds may provide a higher after-tax return. However, investors need to be aware of the risks associated with municipals; credit risk, term risk, liquidity risk, maturity risk, tax risk, and geographic risk.
Credit Risk
While lower grade bonds provide higher current income, it comes with a greater default risk. This additional risk of default relative to the slightly higher yield for lower grade bonds has not provided sufficient additional return to warrant the extra risk, particularly if an investor has risk exposure of more than 5% in any of their individual bond positions. Accordingly, investors should focus on the higher credit quality or insured bonds.
Term Risk
Investors should have an average maturity of no greater than five years. This is due to the fact that longer maturities incur incrementally greater volatility with only a very small increase in current yield.
Liquidity Risk
Municipal bonds have unique liquidity risks not associated with comparable quality corporate or treasury bonds. Due to their less liquid nature, municipal bonds have larger bid/ask spreads resulting in higher transaction costs, particularly for trades under $250,000. These higher costs are compounded by a lack of a centralized transparent trading venue, making it difficult for individuals to compare prices between dealers.
Tax Risk
Tax laws are constantly changing and are rarely predictable, especially over the long term. If, for example, top marginal tax rates rise, municipal bonds become more valuable. Conversely, if tax rates drop, those same bonds will see their value decrease.
Geographic Risk
Many municipal bonds’ ability to pay is contingent on local municipal economic health. When a geographic area such as New Orleans is devastated by a hurricane or other natural disaster, municipalities’ ability to pay their obligations becomes compromised. U.S. Government and corporate bonds have little or none of this risk.
Individual Bonds versus Bond Funds
The advantage of owning individual bonds is the total control of credit quality, maturity, and geographic diversification decisions. Depending on a client’s portfolio size, diversification with individual bonds may be difficult or not cost-effective. Many investors may be better off owning a low cost, short-term municipal bond index fund, such as the Vanguard Limited Term Municipal Bond fund, which has a very low fee (as low as .11% annually), substantial diversification (over 700 bond issues), a 2.7 year duration, and no single bond issue representing more than 1% of the fund.
Variable Annuities
In isolation, there’s nothing wrong with a variable annuity (VA). Their benefits include tax-deferred growth, professional money management, numerous investment options, and a contingent death benefit. Severe deficiencies become apparent when VAs are compared to low cost, tax-efficient investment products such as index funds.
While the tax deferral feature of VAs is a benefit, it is a limited one compared to tax-efficient index funds, which typically retain 95% or more of their total return after taxes. The high expenses associated with VAs more than offset the modest tax savings, compared to index funds.
The biggest problem with VAs is upon withdrawal or death. All of the gain on a VA is taxed at the investor’s marginal ordinary income tax rate, unlike stocks or mutual funds that are taxed at the lower capital gains rates. Upon death, stocks or mutual funds receive a step up in basis with no capital gain tax consequence to heirs. VAs don’t receive a step up in basis and are subject to the full income tax on the gain.
Further, high cost basis “tax lots” of stocks or mutual funds can be selected for sale, minimizing capital gains tax. In contrast, most VA withdrawals are treated as first-in, last-out, meaning all withdrawals are subject to the investor’s maximum marginal tax rate income, until all the gain has been withdrawn. The original principal deposits are not subject to tax, but are the last to be withdrawn for tax accounting purposes.
In addition to less favorable taxation, variable annuities are also very costly compared to index funds. The median expense for VAs is 2.01% versus .29% for Index Funds. Significant sales incentives are offered to VA salespeople – high commissions, bonuses, trips – and unlike mutual funds, they generally offer no discount on commissions for large transactions. When the sales commission feature is eliminated, sophisticated objective advisors simply won’t recommend VAs to investors. An exception to this is if an investor already owns a high cost retail VA with a (substantial) gain. If client circumstances are appropriate, a high-cost retail annuity can be exchanged for a no-load, low-cost Institutional Variable Annuity, without incurring a taxable gain.
Active Management versus Passive Management
Active management can be defined as the endeavor to identify stocks with “superior” prospects (“stock picking”) or attempting when to move in and out of stocks or between different asset classes (“market timing”). By comparison, passive or index management accepts the premise that stocks have the “correct price” as determined, collectively, by market participants.
A typical actively managed fund will turn over the portfolio 95% per year, compared to 5%-20% for passively managed index funds. The additional turnover associated with active management results in more frequent realization of capital gains and, for taxable accounts, creates a “premature” tax liability. This additional tax reduces investment returns 1%-3% per year, compared to more tax-efficient index funds. The accelerated tax can cause a dramatic reduction in wealth over time.
Today, there are thousands of separately managed accounts or mutual funds that are actively managed and tax sensitive. However, since active managers have their “favorite” stocks, investment returns may suffer as the tax liability constraint prevents the manager from selling the stocks he/she doesn’t like. Inherently, there are significant conflicts between the active management approach and tax-minimization. In contrast, passive tax-managed separate accounts or mutual funds don’t have “favorite” stocks and can more easily transact in a tax-favorable fashion. Additionally, since passive funds tend to own many more securities, there will be a greater possibility of tax loss harvesting for better tax efficiency.
Tax-Managed Index Funds
The most advanced products for tax-efficiency are tax-managed index funds (TMIFs). To keep taxes low, there are five primary techniques that TMIFs apply: low turnover, expanded securities trading range, dividend management, tax loss harvesting and avoidance of short term capital gain realization.
Within a TMIF, realized taxable gain from stock turnover will be negligible due to low turnover, matching losses with gains, and “expanded trading range.”
The “expanded trading range” is a set of trading rules that the index fund manager will place on stocks before selling. For example, a small company grows too big to be considered small (for a small company index fund). A TMIF will allow a wider range of price change before selling, thereby postponing or even eliminating a taxable capital gain.
Reducing taxable dividends is desirable as long as the portfolio’s expected return remains the same. All other things being equal, if two portfolios have the same expected return, the one with a lower dividend will produce a higher after-tax return, with a relatively higher portion of the return coming from deferred capital gain.
Dividend management is accomplished in several ways: For example, portfolios are constructed by reducing the percentage of high dividend-paying stocks and increasing low dividend-paying stocks—without sacrificing the financial characteristics of company size or price/book and without changing the expected return of the portfolio. Another technique to minimize dividend income is to postpone the purchase of new securities just prior to the record date of the dividend (for stocks intended to be purchased) or accelerate the sale of a stock just prior to the record date (for stocks that are intended to be sold). This way the total return is not altered, but the taxable dividend has been avoided.
Tax loss harvesting is a technique to further minimize tax. A stock with a loss is sold and replaced with a stock of similar market cap and price/book. The objective with tax loss harvesting is to reduce capital gain liability without changing the financial characteristics of the portfolio. Passive tax-managed funds are currently available for the following asset classes:
- US Core Equity (value and small companies tilt)
- US Megacap
- US Large Cap Value
- US Small Cap Value
- US Small Cap
- US Microcap
- International Large Cap
- International Core Equity (value and small companies tilt)
- International Large Cap Value
- Emerging Markets Core (value and small companies tilt)
- Emerging Markets Large Cap
Tax Efficient Asset Allocation
Some general advantages with owning taxable bonds in a qualified account over holding municipal bonds in a taxable account are as follows:
- Less risk of negative impact due to tax law changes
- No AMT exposure
- No geographic risk
- Better credit quality control
- Better liquidity
- Lower transaction costs
During the non-IRA withdrawal stage the taxable bonds will generally produce higher pre-tax returns. During the withdrawal phase of IRA assets, municipals may provide a slight after-tax advantage, but probably no more than .1% to .5% annually.
Equities Placement
Accumulation Phase
Taxable Account |
Tax Deferred |
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Withdrawal Phase
Taxable Account
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Tax Deferred |
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Conclusion
Astute asset class placement between accounts, utilizing tax loss harvesting, and employing tax-managed index funds can provide the optimal benefits of tax-efficiency with maximum effective diversification. The rigorous application of these powerful tax-minimization techniques can help an investor retain more of their hard-earned wealth and be able to have more spendable income.
