The Problem: Taxes
One encounters a great deal of advertising by mutual fund companies
touting investment performance. The Securities and Exchange Commission requires that all mutual funds publish total return
information in their prospectuses, and we at Metrics Money Management, LLC provide portfolio total return information to our
clients on a quarterly basis.
However, these figures
all state pretax total returns. While this may be necessary to provide a uniform standard by which to compare performance,
it ignores the reality of federal and state income taxes. Federal income taxes on dividends, interest, and short-term capital
gains (for assets held for 1 year or less) are as high as 35%, while the highest long-term capital gains rate is 15%. In addition,
residents of the District of Columbia must pay an income tax with a top marginal rate of 9.5%, while for Maryland and Virginia
residents the top marginal rates are 8.5% and 5.75%, respectively. What really matters to investors is what they are left
with after taxes have been paid – the after tax return.
The following example will illustrate the impact of taxes. Suppose an investor puts $100,000 into an all-stock portfolio.
This investment pays out nothing in dividends or other taxable income, and grows 10% per year for ten years. Now the investor
cashes out – he sells everything. The investment has grown to $259,374. If he were a Virginia resident, 15% of the realized
gain of $159,374, or $23,906.1, is now due the federal government in income taxes, and 5.75%, or $9,164, is owed the state
of Virginia. (More would be owed in Maryland or the District of Columbia.) The net after tax return is $126,303.90 on the
original $100,000 investment.
Now suppose this same
investor bought the same stocks but replaced them with other stocks after every year and a day. Again, assume a 10% per year
rate of growth. These gains still qualify for the lower capital gains tax rate, which is 15% for most investors, and the regular
state income tax rates apply. The tax rate is the same, but the annual trading creates tax liabilities, and the yearly cash
outflow to pay taxes reduces the after tax return to $114,397.92. A full $11,905.98 has been lost to taxes for this Virginia
resident, and the figure would be higher still for residents of Maryland and the District of Columbia.
Finally, assume the same situation except that now all the stocks are held for exactly
one year and then replaced. Now the gains are taxed annually at the regular income tax rate, up to 35%. If our investor is
in the 28% bracket, and is a Virginia resident, the investment in ten years produces a gain of only $85,022.19 after taxes.
Again, residents of Maryland and the District of Columbia would have even less. There is a full $41,281.71 difference, or
41.28% of the original investment, in after tax performance between the most and the least tax efficient methods of managing
the investment. Yet pretax performance was the same in both cases!
Clearly, taxes have a major impact on what we get to keep from our investments.
When one invests in mutual funds, rather than individual stocks or bonds, there are
additional tax considerations. As with individual securities, fund shares sold within one year of purchase for more than the
purchase price face regular income tax rates on the gain. If the securities have been held for more than a year, any gain
is taxed at the more favorable capital gains rate.
However,
funds must pass along their net earnings – interest, dividends, and capital gains - to their shareholders, who pay taxes
on the distributions. The fact that a distribution is reinvested in additional shares does not matter. Dividends and interest
paid out are taxed as ordinary income. (Exceptions: interest on U.S. Treasury instruments are not taxed by the states, and
interest on most municipal bonds are not taxed by the federal government and usually not taxed by the home state.) The long
and short-term capital gains that are distributed are those realized on the sale of stocks that were held by the fund, and
are taxed as their names suggest. The long versus short-term distinction is determined by how long the fund owned the securities
it sold – not by how long the fund shareholder held his or her mutual fund shares. There are two potential tax problems
unique to mutual funds. First, a fund may have large unrealized capital gains if it holds many stocks whose prices have appreciated
since purchase. Should the fund decide to sell some of these stocks, the gain will be passed along to fund shareholders and
will, of course, be taxable. Even if a mutual fund shareholder purchases his or her shares long after the stocks in the fund
have run up in value, should the fund manager decide to sell these stocks, the full gain will be taxable to the new fund shareholder.
Of course, a fund might also have realized or unrealized losses on its underlying securities and these can be used to offset
present or future capital gains. Such a fund would offer tax benefits to the new investor, yet he or she did not suffer the
corresponding fall in the fund’s value caused by the losses.
Second, whoever owns a fund’s shares on its record date will receive any taxable distribution, regardless of
how long the fund shares were held. So, if an investor buys mutual fund shares just days before a distribution, he or she
still receives income and owes the taxes due on it. This is sometimes called "buying a dividend". (On a technical
note, the price of the mutual fund shares will drop by the amount of the distribution, so the value of the investment does
not change. The taxable income received will be offset by a lower sales price when the fund shares are sold. However, if that
day is well into the future, the unfortunate fund investor will lose the time value of the money he paid in taxes presently.)
Our Approach
Metrics Money Management LLC seeks to minimize the impact of taxes on our clients’
portfolios by investing in a tax efficient manner. We do this in several ways.
First, for fixed income investors, we select bonds, bond funds, and money market funds that are
expected to provide the highest income after taxes for each client. Different securities are taxed differently. Municipal
bonds from one’s state of residence are exempt from federal and state income tax, but pay a lower rate of interest than
taxable bonds. Interest on U.S. Treasury bills, notes, and bonds, and the money market and bond funds that invest in them,
are exempt from state income tax but are taxed by the U.S. government. Earnings from corporate and U.S. government agency
bonds are taxed at both the state and federal levels, but the state income tax paid on this income may be deductible for federal
income tax purposes. What is best for each client will require an analysis of his or her specific tax situation.
Second, we strive to keep portfolio turnover low in taxable accounts.
We have demonstrated how, other things being equal, high turnover greatly reduces after tax returns. It does so by 1) accelerating
the realization of capital gains and 2) by not permitting the shareholder to fully benefit from the lower tax rates afforded
long term capital gains. Therefore, we prefer not to trade stocks frequently. Naturally, we also prefer low turnover mutual
funds for taxable accounts, since funds that have high turnover – trade a lot - will tend to have large taxable income
distributions. Index funds, most with very low turnover, are ideal for this purpose.
Third, we utilize a tax-friendly sell selection process. When selling securities of which there
were multiple purchases, we would first sell the higher-basis (higher-cost) shares to minimize realized capital gains. When
we wish to sell shares that have appreciated in value, we seek to find losses that can be realized to offset at least a part
of the gain.
Fourth, we "harvest" losses.
Up to $3,000 per year in capital losses can be deducted from taxable income, with additional amounts carried forward against
future income. There is no limit on the amount of capital losses that can be used to offset capital gains. So, if a client
owns a security in a taxable account that is worth less than what he or she paid for it, we will consider selling it to realize
the loss and reduce the client’s income taxes. If owning this type of security continues to make sense, we would suggest
replacing it with a similar bond, stock, or mutual fund to maintain the same investment profile. After 31 days the loss is
tax deductible, and we have the option of returning to the original security or staying with the substitute.
Fifth, we are mindful of the tax liabilities of mutual funds.
We hesitate to purchase for a taxable account a mutual fund that carries a large unrealized capital gain. Should the fund
manager sell securities in the fund – by choice or out of necessity, i.e., to meet shareholder redemptions – it
would realize large capital gains that would then have to be passed along to the shareholders. Moreover, we will defer the
purchase of a fund in a taxable account if it is about to make distributions, since these will be taxable income to our client,
the shareholder. This is particularly important at year’s end, when funds typically make capital gains distributions.
In a good year, these can be large.
Sixth, we take
advantage of tax-sheltered accounts, such as IRAs. These have the great advantage of deferring the taxes due on income from
investments – interest, dividends, and capital gains – until the time of withdrawal from the account. Over long
periods of time, this postponement of paying taxes, which is really an interest free loan from the U.S. and most state governments,
can result in considerable savings to the investor. Thus, an IRA is ideally suited for bonds and bond funds, which pay interest,
and stocks and stock funds that pay high dividends. Mutual funds with high turnover, and hence significant capital gains distributions,
or those with large unrealized capital gains, would also be better placed in a tax-sheltered account. These securities generate
considerable taxable income, but the IRA or annuity allows the postponement of the taxes due on this income until withdrawal.
A tax-sheltered account is also a great vehicle for portfolio re-balancing – trading stocks for bonds, or vice versa
– since realizing a gain on the sale of an asset in such an account does not result in an immediate tax liability.
On the other hand, tax shelters have one disadvantage –
they convert long-term capital gains, which would be taxed at a lower rate outside the IRA, to ordinary income taxed at regular
rates when funds are withdrawn. Therefore, stocks (or a stock fund with little turnover, such as an index fund) that we expect
to hold for several years and to appreciate in value are best purchased outside a tax- sheltered account, other things being
equal. However, over long periods of time, at least 10 years, the benefit of tax deferral outweighs the disadvantage of the
higher tax rate. So, if a client does not plan to withdraw funds from the tax-sheltered vehicle for many years, owning equities
in these accounts may make sense.
Finally, because
some of our clients are not American citizens, we are very cognizant of tax law regarding non-U.S. investors. US tax liability
will vary for interest, dividends, and capital gains depending on whether one is classified as a resident or non-resident,
and living here or abroad. Proper investment selection with regard to taxes is particularly important for the non-U.S. citizen.
A mistake can be very costly.
All the above notwithstanding,
we should remember that the objective of investing is not to minimize taxes. After all, a portfolio that never grew might
well result in low tax liability, but this would hardly achieve our investment objectives. Rather, we seek to maximize after-tax
returns within the parameters of acceptable risk. Nevertheless, as we have shown, taxes can significantly reduce returns.
Managing investments in a tax-sensitive manner can boost after tax return and enhance the prospect of achieving our clients’
long-term investment objectives.
