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By Samuel Lee

Investing is a lot like harvesting fruit from a tree. The typical investor, overconfident, ignores the smallish, plain but certain fruit dangling within his grasp. He’d rather clamber up the tree in search of bigger, sweeter fruit. So up he climbs, joining the other would-be fruit-pickers. More often than not, they all end up on a narrow branch that can’t support their weight. And they fall.

Sadly, many will pick themselves right up and clamber up the tree again. The smart ones are content to pick all the low-hanging fruit before attempting any acrobatics.

Everyone knows the low-hanging fruit: Diversify your holdings and keep costs down. Taxes are a big cost—perhaps the biggest for high-earners—but are also among the least thought about. I know from experience, because I haven’t thought nearly as hard about taxes as I have about other, ultimately less important things. Mea maxima culpa.

It's easy to show how important taxes are.

Patient Patty and Frenetic Fred are taxed at today’s highest marginal ordinary income tax rate, 43.4%. Patty is a Berkshire Hathaway (NYSE:BRK.B) shareholder. Her favorite holding period is forever. Fred has an itchy trigger finger. He relishes harvesting short-term gains. Assume that over 30 years, the tax code remains the same (I’m aware I’m venturing into fantasy land here) and Berkshire earns 10% annualized without ever paying a dividend. After paying 20% on her long-term capital gains, Patty’s aftertax annualized return is 9.2%, for a tax-cost ratio of 0.8%. Assuming Fred only incurs short-term gains, how much would his portfolio have to return over this period before taxes to equal Patty’s performance? 16.3%. Unless Fred’s real name happens to be Warren Edward Buffett, the chances of him beating Patty after taxes are about as good as a paper dog catching an asbestos cat in hell.

Even if Fred paid only the 20% long-term gains tax on his earnings each year, he’d need a still-sizable 11.5% annualized pretax return just to break even with Patty. A 1.5% annual excess return over 30 years is like playing in the NBA—doable, but only for the elite.

Frenetic Fred is foolish because his fast-trading strategy fights the brutal arithmetic of compounding. For each dollar in taxes he pays today, he’s deprived of all the subsequent compound interest that dollar could have generated. And for each dollar he keeps, he has to pay taxes on whatever earnings they generate each year, and he forgoes the compound interest those taxed dollars could have generated. Fred, in his eagerness to pay taxes, plays the Grim Reaper, pruning each taxed dollar’s “family tree.”

Patient Patty is prudent because her buy-and-hold strategy benefits from compounding. Her tax bill is deferred, so each year her gains build on each other. She earns interest on her interest. Deferring taxes is economically equivalent to taking out an interest-free loan from the government and investing the sum in the asset that has the deferred gain. Noncallable, interest-free leverage is both rare and precious, and you need a very good reason to pass it up.

Sadly, the typical household holds on to losers in hopes of making it back to break-even, sells winners to lock in gains, churns its taxable accounts, does most of its tax-loss harvesting in December, and too often owns high-yield assets in taxable accounts unnecessarily.

If that describes you, you’re in good company. A host of studies document bad tax moves by households. Though most households sensibly keep bonds in tax-sheltered accounts, about a third unnecessarily own them in taxable accounts.1 A rare handful will own municipal bonds in tax-deferred accounts. A more common and costly mistake is how eagerly and aggressively households realize gains. The magnitude of the losses from inefficient tax management has not been well-studied owing to the difficulty of the task, but my intuition leads me to think it’s very high.

How does a household without the means to hire a clever accountant manage its taxable investments? Finance professors have built fancy models to answer this question, and their findings are simple: 1) Keep high-yield assets in tax-deferred accounts; and 2) defer as much taxes for as long as possible in taxable accounts.

I’ll deal with each in turn.

Asset Location
Tax-efficient asset location is putting assets in tax-deferred accounts such that the government’s tax subsidy is maximized. In practice, this means stuffing your high-yield bonds, closed-end funds, REITs, high-turnover active funds, and other big sources of ordinary income in tax-deferred accounts. And it means keeping stocks in taxable accounts. The pecking-order rule implies that asset allocations should be dramatically different between taxable and tax-deferred accounts.

However, the models that spit out this conclusion assume interest rates higher than what we see today. When bonds and other tax-unfriendly assets are throwing off little income, owning them in a taxable account is a defensible choice (for example, a short-duration bond fund). However, once the yield reaches 3% and above, keeping them outside of a tax-deferred account becomes less tenable.

The models also assume equities in the taxable account aren’t churned. An investor who aggressively realizes mostly short-term capital gains with his equities may be better off sticking his stocks in a tax-deferred account.

Beyond purely minimizing taxes, there are several reasons to violate the pecking-order rule. The first is to maintain a liquidity buffer to avoid ever having to tap tax-deferred accounts before retirement, which can induce hefty tax penalties. Even with this consideration, it’s hard to find a scenario in which deviating from the asset-location rule makes sense, according to simulations.2

Another reason to own bonds in taxable funds is if you own active equity mutual funds that distribute lots of capital gains. In this case, it can make sense to own municipal bonds in a taxable account and the active equity funds in tax-sheltered accounts.3

The final reason is tax diversification. If the relative tax rates of both stocks and bonds are volatile over time, a risk-averse investor might justifiably own more balanced stock-bond allocations in both taxable and tax-deferred accounts to smooth out the effects of different possible tax regimes.4 Historically, the relative tax burdens of stocks and bonds have been volatile. However, I don’t find this a compelling reason to incur a sizable tax burden now, because tax-code changes are usually telegraphed by Congress far in advance.

The take-away is common sense: Don’t own high-yield assets in a taxable account.

Deferring Gains
The second component of tax-efficient investing is deferring the realization of capital gains for as long as possible. Failing to do so is one of the biggest mistakes investors commonly make.

The U.S. tax code offers a tax-timing option to investors. It taxes capital gains only upon sale of the asset and allows investors to offset them with realized capital losses. When realized losses exceed gains in a year, an investor can deduct up to $3,000 of realized capital losses from his income. Any realized losses above that can be carried forward to offset capital gains in later years.

The optimal way to exercise the tax-timing option is to defer capital gains taxes indefinitely while immediately realizing the benefits of the capital-loss tax deduction, especially short-term capital losses.

Rob Arnott, Andrew Berkin, and Jia Ye5 quantified the value of the tax-timing option by running simulations of portfolios of 500 stocks over 300 months (or 25 years). Each simulated portfolio had an average monthly dividend return of 0.12% and a price return of 0.54%, for an average annual total return of close to 8%. Each stock’s monthly return was randomized such that the annualized standard deviation was around 31%, and the market return’s annualized standard deviation was around 15%. (Though the study’s authors don’t mention it, I assume that the stock returns were correlated with each other because 500 uncorrelated assets with even extremely high idiosyncratic volatilities would combine into a very low-risk portfolio.) In short, each simulation run created a random 25-year history for 500 stocks. The simulation was run 300 times.

Each simulation had two portfolios: a buy-and-hold strategy and a tax-sensitive strategy. Each month the tax-sensitive strategy sold any stocks that had a loss and immediately bought them back. The wash-sale rule prevents the tax-loss benefit from accruing to an investor who buys back within 30 days a “substantially identical” security. The study’s authors claim that including the wash-sale rule didn’t affect their overall results much. Each quarter the strategy took out any tax obligations from capital gains and reinvested any tax savings from loss harvesting.

At a 35% marginal tax rate, the median gain of the tax-loss-harvested portfolios over the buy-and-hold portfolios was about 0.50% annualized over 25 years. The benefit sounds unexciting until you realize that the buy-and-hold benchmark is itself a tax-efficient strategy. Against a high-turnover strategy that repeatedly incurs big capital gains, the margin of victory for a loss-harvesting strategy is huge—easily 2%–3% annualized. Generating that kind of extra return over decades is no mean feat.

Depending on your personal tax circumstances and beliefs about future market volatility and returns, the study is either too optimistic or too pessimistic about the benefits of tax-loss harvesting. If you’re fortunate enough to be in the top tax bracket, tax-loss harvesting is almost certainly a good idea.

A way to enhance the tax-deferred strategy is to employ tax-lot accounting, which allows you to realize losses and gains on specific tax lots in a more precise manner. Fortunately, this has become a lot easier in recent years as the cost of computational and storage power has fallen.

Bizarrely, many investors harvest losses only in December. Not only do they give up the opportunity to defer more gains, their collective tax-loss selling artificially depresses the prices of beaten-down stocks. If anything, they should avoid tax-loss harvesting in December.

The take-away: Sell losers aggressively throughout the year, except perhaps in December; be loath to sell winners, especially when doing so will incur short-term capital gains taxes.

Taxes or Alpha?
“More investment sins are probably committed by otherwise quite intelligent people because of ‘tax considerations’ than from any other cause.”— Warren Buffett, Jan. 18, 1965, letter to limited partners.

The biggest perceived trade-off of tax management is the loss of investment flexibility. Pure tax considerations would have you hold on to overvalued stocks to defer gains and sell undervalued ones to quickly realize losses. Every investor over the course of engaging in a highly tax-aware investment strategy will experience the pain of losing money owing to a tax-driven decision.

I think it’s a mental illusion. The gains from tax-loss harvesting and deferring taxes are abstract, realized over decades, but any losses are concrete and piercing, especially when you “knew” something was over- or undervalued. With hindsight, the market looks a lot more predictable than it truly is.

The key assumption of the trade-off argument is that you’re able to pick out winners and losers in the first place. A study by Eugene Fama and Kenneth French6 suggests that if you had a crystal ball that could identify and invest in the top 2% of managers sorted by true skill, your expected excess return is 2.5% before fees. (In statistics jargon, their true gross alpha is 2.5%.) Given how high the hurdle is for active management, it suggests that incurring unnecessary tax costs for the sake of an investment thesis must also jump a high hurdle indeed.

But what about that Buffett quotation? Well, when Buffett got around to writing Berkshire Hathaway’s 1993 shareholder letter, his tone had changed dramatically. He spends six paragraphs on an ode to deferring taxes through an extended analogy that involves comic-strip characters Li’l Abner, Appassionatta Von Climax, and Old Man Mose. Buffett takes his tax management seriously. You should, too.

While I can’t offer specific tax guidance, it’s clear there is some low-hanging fruit most investors can pick. The basics come down to the following:

1) Put high-yield assets in tax-deferred accounts. I’d go as far as to say you should contribute the maxi-mum to your IRA and 401(k) or 403(b) every year starting as soon as possible, because that tax-deferred space disappears forever if you don't use it. What if you have a mortgage? Given the choice between making additional payments on it or contributing more to a tax-deferred account, it’s often much better to do the latter.7 Keep in mind, this is from a purely financial perspective. Some find having debt hanging over their heads distressing, so paying down a mortgage in lieu of making contributions to tax-deferred accounts could be sensible.

2) In taxable accounts, stick with low-cost, low-turnover funds.

3) Furthermore, harvest tax losses throughout the year, not just in December. You may even want to avoid tax-related selling that month.

4) Avoid realizing capital gains if you can help it in order to extend for as long as possible the zero-interest-rate loan from Uncle Sam.

5) Treat taxable investments like spouses—intend to keep them around forever, because divorce is heart-breaking and expensive.

6) Don’t “wed” a fund that might meet an untimely liquidation. In taxable accounts, stick with big, broad funds from Vanguard, iShares, and State Street. They’ll likely be around for decades; the same can’t be said for second-tier ETF providers.

Notes

1 Daniel Bergstresser and James Poterba. “Asset Allocation and Asset Location: Household Evidence from the Survey of Consumer Finances.” Journal of Public Economics, 2004.

2 Robert M. Dammon, Chester S. Spatt, and Harold H. Zhang. “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing.” Journal of Finance, 2004.

3 John B. Shoven and Clemens Sialm. “Asset Location in Tax-Deferred and Conventional Savings Accounts.” Journal of Public Economics, 2003.

4 Lorenzo Garlappi and Jennifer Huang. “Are Stocks Desirable in Tax-Deferred Accounts?” Journal of Public Economics, 2006.

5 Rob D. Arnott, Andrew L. Berkin, and Jia Ye. “Loss Harvesting: What’s It Worth to the Taxable Investor?” First Quadrant Investment Management Reflections, 2001.

6 Eugene F. Fama and Kenneth R. French. “Luck Versus Skill in the Cross- Section of Mutual Fund Returns.” Journal of Finance, 2010.

7 Gene Amromin, Jennifer Huang, and Clemens Sialm, “The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings.” Journal of Public Economics, 2007.

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A version of the following article first appeared in the July 2013 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Low-Hanging Fruit: On The Importance Of Taxes In Investing