Unless you happen to be a certified public accountant or related to one, the topic of taxes you pay on your investments probably has as much appeal as a root canal. Understood. Nonetheless, it’s a topic well worth focusing on.
That’s especially true if you invest in mutual funds, which are required to distribute realized gains and income to shareholders. Over the 10 years through 2012, the actual return to investors in the average stock mutual fund shrank by eight-tenths of a percentage point, annualized, because of taxable distributions, according to research from Lipper, the fund-data supplier.
That represents more than 10 percent of the annualized gain for stock funds over that 10-year stretch. Taxable bond funds received a tax haircut of 1.8 percentage points, annualized, during that period, amounting to more than 20 percent of the annualized return for those funds.
“Annual expense ratios get a lot more attention, but not understanding the potential tax drag of what you own and what type of account you own it in can be a bigger issue,” says Tom Roseen, head of research services at Lipper.
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Even if you’re not partaking of mutual funds — or at least those with a habit of generating big tax bills — and you’ve been pleased with your portfolio’s tax efficiency in years past, Robert Keebler, a CPA in Green Bay, Wis., expects many investors to suffer “painful sticker shock” when they complete their 2013 tax returns.
Last year, a net investment income tax of 3.8 percent came into play for couples with modified adjusted gross income above $250,000 and for individuals with more than $200,000. (The figure is typically close to your adjusted gross income reported on Line 37 of your federal Form 1040.)
Last year, the top income-tax rate rose to 39.6 percent from 35 percent, and gains on investments sold in less than a year are taxed as ordinary income. The top long-term capital-gains rate also rose, to 20 percent from 15 percent.
“There’s not one big thing you can do to minimize taxes, but there are a series of small decisions you can make at the margins that, in the aggregate, will leave you with more money,” said Timothy Steffen, director of financial planning for the wealth-management group at Baird.
To shield as many investment dollars as possible from taxes, you can maximize what you tuck into tax-deferred retirement accounts. This low-hanging fruit still seems to elude many people. Vanguard reports that 30 percent of participants in 401(k) plans it administers who had income of at least $200,000 in 2012 did not contribute the maximum. For those with an income of at least $100,000, the figure was 64 percent. In 2014, anyone under 50 years old can contribute up to $17,500; if you’re of AARP age — 50 and older — you can contribute up to $23,000.
And don’t forget individual retirement accounts. Anyone can invest in a nondeductible IRA, regardless of income, and receive the benefit of tax-deferred growth. And couples filing a joint tax return with modified adjusted gross income below $181,000, or single filers with income below $114,000, can stuff up to the maximum of $5,500 a person into a Roth IRA ($6,500 if you’re at least 50).
With a Roth IRA, contributions are made with after-tax dollars, so there’s no upfront tax break. But your money grows tax-deferred, and withdrawals in retirement will be tax-free.
If you have investments in tax-deferred accounts, as well as regular taxable accounts, it’s worth considering the art of asset location. The standard advice has always been that investments that throw off income taxed at your income-tax rate belong in a tax-deferred account. The theory is that for most of us, our income-tax rate is higher than our capital-gains rate.
That has typically been an argument for keeping your bond holdings in your 401(k) and IRA, since bond interest is taxed as income. But Michael Kitces, director of planning research at the Pinnacle Advisory Group in Columbia, Md., says that today’s low interest rates on high-grade bonds make that rule of thumb less important. Even if you are paying federal income tax of 39.6 percent on the interest from a core bond fund, the fact that the fund’s yield is just 2 percent or so means that there’s not much income in the first place.
Kitces suggests a twist. “Focus on making sure your highest-returning and least-tax-efficient investment is inside your 401(k) or IRA and your most tax-efficient investment is in your taxable account,” he said. “And don’t worry about everything else. Just get those two right, and you’ve done yourself a ton of good.”
Likely suspects for a tax-deferred account include high-yield, or junk, bonds and real estate investment trusts and any actively traded portfolio that generates frequent short-term gains. Low-turnover stock index mutual funds or exchange-traded funds and municipal bonds are often the best bets for taxable accounts, as they are prone to generate low, or no, taxable distributions.
While it may be heresy to index purists, actively managed funds can still be a solid investment, even with their typically higher tax bill. Yes, the performance of the average equity stock fund has failed to keep up with its indexing brethren. But there are exceptions.
“What matters is your after-tax return, not whether a fund is 99 percent tax-efficient,” said Daniel Wiener, chairman of Adviser Investments. “If an actively managed fund delivers superior returns after tax, that’s what I care about.” That said, if you own an actively managed fund, it may be a candidate for your 401(k) or IRA.
If you were subject to the new, 3.8 percent net investment tax in 2013, you may be able to reduce this year’s bite. Here’s how the tax works: If you have investment income, and your modified adjusted gross income is above $250,000 ($200,000 for individuals), you are in its cross hairs. The 3.8 percent tax is levied on the lesser of these two figures: the amount of your income that exceeds those thresholds of modified adjusted gross income or the sum of all the net investment income you had in the year.
If your income is well above the appropriate modified adjusted-gross-income threshold, it’s likely that your net investment income is what will come into play. In that case, Keebler says that one tax-reduction strategy is to consider municipal bonds because their interest is not part of the calculation for net investment income.
Just make sure you steer clear of private-activity municipal bonds because interest from such bonds is subject to the alternative minimum tax. Alas, even tax-exempt investing has its traps.