1. Destination:
Tax-Smart Investing
Strategies to Help You Keep More of What
You Make
In the late 1990s, mutual fund asset values skyrocketed, generating
significant capital gains for investors. So when the tech bubble burst in the
early 2000s, and these gains were reported to the IRS as part of routine
year-end reporting, some investors found themselves in the unfortunate
position of losing money AND owing taxes.
Could this scenario repeat itself?
Given the likelihood of major changes in the federal tax code in the future
â and with the exhaustion of tax-loss carryforwards â investors could once
again face the possibility of less-than-ideal tax management.
Taxes â especially when not managed properly â can erode investment
gains and minimize progress towards your financial goals. And uncertainty
around taxes can add to your psychological discomfort as well as increase
the potential to make the wrong decisions.
In times like these, every investor needs to examine and possibly rethink
investment tax management. So this article will discuss:
âșâș The evolving tax code and what it means for you,
âșâș Why investors may well be paying more taxes than necessary, and most
importantly,
âșâș The tools available to fight uncertainty and help you keep
more of what you make â in any market environment.
2. Postponing the Inevitable? How Much Damage Could Be Done?
This being an election year, the forecast is that there will Itâs important to keep in mind the impact of taxes on
be major changes to the tax code next year but the actual hard-won investment gains. According to the Investment
changes are hard to forecast. Let us instead deal with what Company Institute (ICI), at year-end 2008 more than 92
is certain. The current Federal Income Tax rates are set to million shareholders (82% individuals, 18% institutions)
expire at the end of 2012. Starting January 1, 2013 several owned the majority of the $9.6 trillion assets invested in
tax changes take effect including*: mutual funds that year.1 These investors paid approximately
$736 million in 2009 due to short-term capital gains taxes,
âșâș The top marginal income tax bracket will move to 39.6%,
$149 million in long-term capital gains taxes and $12 billion
up from 35%.
because of taxes on dividends. Basically, these investors on
âșâș The long-term capital gain rate will move to 20%, up from
average gave up almost one percent (0.98%) of earnings to
15%.
taxes. And while those numbers are disturbing, they came
âșâș Dividends would no longer have any preferential tax in a year when the tax burden was relatively light. Finally,
treatment which currently exists for âqualifying dividendsâ consider that those taxes covered little more than holding
âșâș Two new taxes will come into play as a result of The the fund and reinvesting gains, essentially a buy-and-hold
Patient Protection and Affordable Care Act (PPACA) strategy.
ââ The Medicare tax rate on households with earned Hereâs another way to assess the damage of taxes. A
income over $250k will be increased from 1.45% to hypothetical $100,000 portfolio invested in 60% stocks and
2.35%. The same increase will occur for singles with 40% bonds in 1979 would have grown to $3.17 million before
earned income over $200k. taxes by 2011. However, with no efforts to mitigate the tax
ââ A new Medicare tax will be introduced for the same effect, Uncle Sam would have eaten almost 49 percent of
group on investment income at a rate of 3.8%. The the gain, lowering the investorâs wealth to just over $1.6
Surtax applies to: taxable interest, dividends, capital million.2
gains, passive activity income, rents, royalties, and
annuities.
âșâș The reduction to the social security tax rate is restored to
6.2%, currently at 4.2%.
âșâș The currently favorable estate & gift tax laws expire at
the end of 2012. The estate and gift tax exemption moves
down to $1M with a 55% maximum tax rate. Currently
there is a $5M exemption and a 45% maximum tax rate.
** Source: Parametric Portfolio Associates: 60% Russell 3000; 40% Barclays Capital Aggregate; No Liquidation. Interest income and dividends are taxed annually at historical top
marginal tax rates; capital gains are realized at 50% per year and are taxed at the historical long-term capital gains tax rate at the time. Past performance is no guarantee of future
results.
**A hypothetical $100,000 portfolio before taxes (invested 60% in stocks and 40% in bonds) held for 33 years would have grown to about $3.2 million. If the portfolio was taxed like
an average mutual fund, it would have lost 49% of its value, due to taxes paid and earnings lost on that money. Tax-managed investment strategies are designed to minimize capital
gains distributions and enhance after-tax returns. As of 12/31/11. Since inception 12/2002. There is no guarantee that distributions will not be made in the future.
3. Itâs Not What You Make, Itâs What You Keep
Taxes Reduce Performance Over Time
Hypothetical Growth of $100,000**
$3,500,000.00 49% Lost to Taxes Before-Tax Portfolio: $3,174,000
$3,000,000.00
$2,500,000.00
$2,000,000.00
$1,500,000.00
$1,000,000.00
$500,000.00 After-Tax Portfolio: $1,613,000
$0.00
1979 1987 1995 2003 2011
Out With the Old, In With the New Parametricâs Langstraat believes that âInvestors need
a consistent, systematic, year-round approach to tax
âTaxes take an enormous bite out of an investorâs return
management in their portfolios.â However, there are minimal
â but the good news is that you can do something about
opportunities with traditional mutual funds, where tax
it,â said Brian Langstraat, president of Parametric Portfolio
management is mostly limited to deferring capital gains or
Associates, whose firm helps investment managers
minimizing dividend distributions.
implement tax management strategies. Parametric
implements a tax overlay structure within SEIâs Separate More to the point, the manager of a traditional mutual fund
Account program. buys and sells securities with the interests of the fund in
mind, and not necessarily the tax consequences of the
Historically, according to Langstraat, most investors and
investor. Itâs for this reason that we offer tax-managed funds
their financial advisors have focused only on cutting taxes in
and tax-efficient separate account strategies.
November and December or only in years where investors
have capital gains.
Firms like Parametric argue that there is a better way to
Tools to Ease Your Uncertainty
help protect the investorâs return throughout the marketâs The list of tools available to managers of tax-managed
ups and downs. It begins with the admission that tax portfolios and other tax-advantaged investments reflects
management cannot be a part-time endeavor. Given the their growing popularity. Think of each as navigational tools
potential damage of overpayment, the management of taxes to help the investor stay on course to his or her investment
must be a cornerstone of an investorâs planning process. goal. While none of these tools are guaranteed, they can be
It calls for employing new techniques and strategies from very helpful in managing tax consequences:
investment managers and more sensitivity to the tax
Tax-lot accounting: A method of accounting for a securities
consequences of portfolio implementation.
portfolio in which the manager tracks the purchase, sale
âInvestment return is number-one, tax management is price and cost basis of each security. This allows the
one-A,â said Steve Konopka, Director, Investment Services manager to âswapâ a batch of stocks with long-term gains
with SEI. Konopka admits to being frustrated when investors for a batch with smaller, short-term gains.
and their advisors ignore tax management until year-end, at
Loss harvesting: Allows the manager holding a stock at a
which point options are limited.
loss to sell all or part of it to realize the loss and create an
âIf the investor only does tax management at year-end and âassetâ that may help offset some future gain.
the market went up, thereâs not much that can be done at
Wider rebalancing ranges: A wider rebalancing range
that point,â he said. âBut managing taxes throughout the
can help reduce the number of trades made to keep the
year means the investor can take advantage of the ups and
investorâs portfolio within a range of the target allocation,
downs of the market and benefit from that volatility.â
say a 60% equity and 40% bond allocation, which may lead