By Gregg Fisher, CFA
After January 1, 2013, the U.S. tax regime will change, and potentially quite dramatically. We expect higher taxation, but apart from the 3.8% health care surtax on net investment income for higher-income households, we still don't know the full scope of change. Specifically, we're waiting to see whether the Bush-era tax rates on earned income, dividends, and capital gains will revert to their previous (higher) levels. In what is destined to be a hectic and contentious lame duck session, Congress will presumably take up this and other thorny tax issues in the short eight weeks between the November elections and the close of 2012.
Regardless of the outcome in Congress, investors should do a better job now integrating their taxes and Form 1040 with their investment portfolio strategy. I have reviewed thousands of tax returns over the past 30 years and advised numerous clients on investing for the past 20 years. I never cease to be amazed at how people compartmentalize their financial lives and separate their tax returns from their investment portfolios, which is an excellent example of what behavioral finance calls "mental accounting." Taxes and sound tax management should be key considerations when formulating and executing an investment strategy.
Taxes and Investment Returns
I have long believed that investors need to focus more on their post-tax returns. After all, for taxable investors, how much return their investment earns matters less than how much of that investment return they actually get to keep. Figuring out this amount may require some effort. For example, most mutual funds highlight returns only on a pre-tax basis. A colleague from NYU Poly and I conducted a study of mutual fund shareholders from January 1, 1996, through December 31, 2010, and concluded that the average equity fund investor surrendered 1.3 percentage points, or 20% of that 15-year period's 6.66% annualized return, to the taxman. (Note: We assumed 35% income tax and 15% capital gains tax rates on annual profits across all funds.) Clearly, the tax bite is a significant cost and source of inefficiency in investing.
Like inflation, taxes erode your investment returns over the long run, but unlike inflation, the taxes you pay on investment gains are one domain over which you do exercise a considerable degree of control. You can view taxes as a transaction cost, one that is higher even than investment management fees (a cost that many investors obsess over).
I believe that adept tax management can add a full percentage point each year to an investor's after-tax return. One point may not sound like much, but when you compound returns over long periods of time, a one-point advantage can end up being enormous. For example, let's say you invest $100,000 for 30 years. If your after-tax compounded return is 6%, that money will grow to $574,349, but if the return is just a point higher, 7%, the end sum will be $761,225. That's 39.4% more profit on your investment.
Learn to Love the 1040
I firmly believe that a line-by-line analysis of your 1040 will make you a much better investor. Handing off your 1040 to a CPA is no excuse for failing to analyze this valuable document for clues to better investing. Typically, your accountant is not analyzing your 1040 with an eye to active tax management, or thinking through the investment implications of your tax situation. And remember, a dollar saved on taxes is a dollar more that can be invested. With the magic of compounding over time, those extra invested dollars can help bring you closer to your tangible long-term investment goals of buying a house, putting the kids through school, or saving enough for retirement.
Every one of the 77 lines on the Form 1040 (many of them summaries of statements, such as Schedule B or Schedule D) is an excerpt from your financial story and a potential roadmap to better investing. You should be on the lookout for inefficiencies when you study your tax return because identifying such inefficiencies will help you make better investment decisions. I'll provide several brief examples of ways to reduce or to defer taxes.
Mining the Tax Code
Consider the important investment categories of interest earnings (lines 8a and b), dividends (lines 9a and b), and capital gains and losses (line 13). I suggest that you look at interest income together with the cost of your debt (e.g., student loans, mortgages, and credit cards). Taxable interest creates a tax liability and raises adjusted gross income (AGI). Depending on your tax rate, it could be an indicator of whether shifting some of your taxable account money into tax-exempt bonds, such as municipal bonds, is sensible. Because interest earned on high-quality bonds is so low these days, if you're heavily invested in low-yielding taxable or tax-exempt bonds, it may make sense to cash in some of those assets to pay down or pay off your mortgage and other debt.
For dividend income, check to see if you're generating "qualified dividends" (currently untaxed or taxed at 15%, depending on your income, although note that this tax status could disappear in 2013) or dividends that are fully taxable as ordinary income, such as distributions from REITs or mutual funds. If the dividends are being taxed as ordinary income, then quite possibly these assets would be better placed in a tax-deferred account.
When it comes to investment capital gains and losses, one important method of reducing taxes and boosting investment returns is tax-loss harvesting-the practice of selling securities in the portfolio at a loss and applying those losses to offset realized taxable gains. In effect, by recognizing losses already incurred for tax purposes, you're increasing the amount of net-of-tax money available for investment and thus increasing the amount of capital working for you. But note that if you expect your taxes to rise dramatically next year, instead of the usual tax-loss harvesting, you may want to consider deliberately booking capital gains this year and deferring losses into next year. In this way, you can pay taxes now at a lower rate and diversify your equity holdings.
None of us have any control over tax rates, but investors can make smarter decisions when they focus on after-tax returns and connect the dots between their tax documents and their investment portfolios. It's important to remember, however, that taxes are only one component of your total investment picture; a strategy that simply tries to lower your payments to Uncle Sam may not be the best one for your personal needs or for building retirement income. Nevertheless, now is a good time for investors to examine their portfolios to determine if they are designed for higher taxes. If they are not, it might be time to make some changes.
IMPORTANT DISCLOSURE INFORMATION
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