It’s Time to Make Taxes Less Taxing
Investors should consider a complete approach to lower the tax drag on investment returns.
SUMMARY
- Investors face the risk of losing a larger portion of portfolio returns to taxes – highlighting the need for a tax-aware investment approach.
- The impact of this “tax drag” on investor portfolios can be significant over long time frames due to compounding.
- To address the tax drag, we think investors should take a three-pillar approach that focuses on asset allocation, asset location and asset management.
Taxes are taxing on investment returns. While many investors focus on the effects of various costs on pretax returns, fewer appreciate the true impact taxes have on performance. By overlooking the impact of taxes, these investors could see more than half of every dollar earned consumed by taxes.
The good news is that timeless and time-tested techniques can help counter the effect of taxes, many of which can be adopted without incurring additional costs. Investors seeking tax relief may already be employing one or two tax management techniques, but that may not be enough to offset the tax impact on returns. A combination of these techniques may help investors reduce the tax burden and protect their wealth.
With higher tax rates now a reality – and the potential for increased rates on investments in the future – there may be no better time for investors to take a holistic view of tax management. The first step is to understand how the tax landscape has changed dramatically by determining exactly what you pay in taxes on your investments. At Eaton Vance, we created the Investment Tax Center to help investors get a handle on investment taxes they pay out each year.
Determine your actual tax rate
For many investors, it’s easy to focus only on returns and forget about how gains and earnings are taxed. The same may not have been true in 1963, when the top marginal tax rate was 91% for those married filing jointly with income over $400,000 – or $3 million after adjusting for inflation (Source: Tax Foundation). Today’s highest marginal tax rate is far below that level, but ignoring how gains and earnings are taxed is still very costly for investors.
As a result of tax increases included in the American Taxpayer Relief Act of 2012, taxpayers in the top federal tax bracket who also live in a high-tax state (such as California or Oregon) could be subject to a combined federal and state marginal tax rate of more than 50% on taxable investment income. Left unchecked, this can lead to an unwelcome surprise come Tax Day.
The first step investors can take toward tax efficiency is to determine what their actual tax rate is on various forms of investment income. Our Investment Tax Center includes an interactive tax calculator to help determine the different tax rates on:
- U.S. Treasurys.
- Municipal bonds (in-state and out-of-state).
- Taxable fixed income.
- Dividends (qualified and non-qualified).
- Capital gains (short and long term).
- Withdrawals from retirement accounts.
The results can help investors consider some straightforward steps to lower the impact of taxes significantly. This may help them keep more of what they earn today, and if tax rates increase in the future.
Are higher tax rates coming soon?
Recent tax hikes are still fresh in the minds of U.S. investors, but more tax changes could arrive sooner than many expect. Outsized federal budget and deficit challenges point to a future of rising taxes (Exhibit B). The deficit challenge is exacerbated by the state of entitlement programs like Social Security and Medicare. Spending on all such programs accounted for 60% of the federal budget in 2014 (Source: Congressional Budget Office).
With these costs expected to grow, the possibility of future tax hikes is very real. In early 2015, President Obama proposed raising the top capital gains and dividend rate to 28%, which equates to nearly an 87% increase from only a few years ago. Even if these recent proposals are dead on arrival, we think it’s clear that taxes on investment income are squarely in the crosshairs.
Compounding the tax drag
Rather than looking at tax effects investment by investment, investors should consider the impact of taxes on their entire portfolio. Exhibit C is an example of how taxes can shrink a portfolio’s return dramatically. Beyond the sheer amount paid in taxes in a single period, investors must also weigh the opportunity cost of not being able to reinvest those lost dollars and potentially benefit from compounded earnings over multiyear periods.
Losing 30% of portfolio returns in a single period can be jarring for many investors. Even more surprising is the substantial effects of taxes over longer time periods. Consider three scenarios for a hypothetical $100,000 portfolio that earns 6% return each year over 20 years:
- If 100% of the returns are subject to the short-term tax rate of 44.59%, then the after-tax return is reduced to 3.40% and the portfolio grows to $192,342.
- If the investment manager is more tax-aware, so that 100% of the returns are subject to the long-term rate of 24.99%, the after-tax return is 4.57% and the portfolio grows to $241,199.
- If the investment manager is perfectly tax-efficient and all net gains are deferred or offset by realized losses (and there are no dividends), then the after-tax return is the same as the pretax return of 6%, and the portfolio grows to $320,714.
Exhibit D charts the returns of these three hypothetical portfolios over time. While this is admittedly a simplistic case, it shows that taxes are important and worthy of careful consideration by investors and their advisors. Investors must also weigh the opportunity cost of not being able to reinvest those lost dollars and potentially benefit from compounded earnings.
Indeed, the long-term “tax drag” on returns can be stronger than investors realize, potentially jeopardizing their ability to attain key financial goals such as a comfortable retirement or a child’s education. Techniques that can mitigate some of this drag are highly valuable, especially to long-term investors.
Three-pillar approach to tax efficiency
Once investors can quantify the impact of taxes on their portfolio, a thorough tax analysis of their investments can begin. We think that a tax-aware investment strategy can be broken down into three pillars:
- Asset allocation.
- Asset location.
- Asset management.
- Determining an allocation
Investors should already be familiar with asset allocation. This pillar includes selection of asset-class weights (equities, fixed income and cash) within a portfolio. There are important considerations in this step, as a taxable portfolio needs to be optimized for after-tax returns. As mentioned before, our Investment Tax Center may be helpful when weighing portfolio options and the potential impact of taxes.
- Location is as important as allocation
For investors with taxable, tax-deferred and tax-exempt accounts, deciding on the placement of investments is crucial to tax efficiency. The use of asset location to minimize taxation is an overlooked aspect of short- and long-term financial planning. Investors may rely on asset location as a simple yet effective way to add value to a portfolio without incurring additional costs.
The underlying characteristics of an investment will help determine whether they live in a taxable, tax-deferred or tax-exempt account. Let’s start with fixed-income investments. Continuing with our example of a married investor living in New York City with the highest marginal tax rate, Exhibit E breaks down the tax rates on different sources of fixed income.
From an asset location perspective, investors should consider placing U.S. Treasurys and most other fixed-income investments (particularly high-yield bonds) in tax-deferred or tax-exempt accounts, such as IRAs and Roth IRAs, due to the relatively higher tax rate on these types of income. Placing these assets in tax-deferred accounts may potentially result in higher aggregate returns over time.
On the other hand, investors should consider holding municipal bonds (and funds that invest in such bonds) in their taxable accounts, as the income on these bonds is exempt from federal taxes. Additionally, in-state munis are also exempt from state and local taxes. This tax exemption can become all the more valuable in a rising tax setting, especially for tax-sensitive investors in upper tax brackets.
Asset location is also important when it comes to equity investing due to differing tax rates. Equities (and funds that invest in equities) may wield an inherent tax advantage over many other asset classes. This is primarily because much of a stock’s (or stock fund’s) total return may come from long-term capital gains, which are not taxed until paid out and, even then, are taxed at lower rates than ordinary income. Likewise, qualified dividend income (QDI) will still be taxed at the lower long-term capital gains rates.
For these reasons, investors should be reluctant to give up the long-term capital gains treatment – even for high-yielding stocks with QDI – by placing them in a tax-deferred or tax-exempt account. On the other hand, investors in capital appreciation strategies with high turnover – such as a hedge fund allocation – should consider placing these allocations in a tax-deferred account. Investors should consult their tax professional to judge whether the tax rate differential between ordinary income and long-term capital gains warrants putting their equity holdings in taxable or tax-deferred accounts.
- Asset Management
Once assets have been allocated and located, they still need to be managed for tax efficiency. For example, investors could become overexposed to a single security over time. Diversifying that position could become costly from a tax perspective if that security has appreciated significantly. This problem is particularly acute for high-net-worth investors subject to the highest marginal tax rate.
Thankfully, there are several asset management techniques investors can employ in their portfolios to help mitigate the effect of taxes, several of which can be implemented at no additional cost.
- Buy and hold: This is the simplest technique on this list. Using a long-term perspective when investing can delay capital gains recognition. This can also help keep unnecessary turnover low, potentially minimizing short-term gains and transactions costs.
- Tax loss harvesting: Not all turnover in a portfolio should be considered bad. Use tax loss turnover in a disciplined fashion to harvest losses that can help offset gains taken elsewhere in the portfolio.
- Utilize SMA portfolios: With a separately managed portfolio, an investor may better manage his or her own tax liability by deciding specifically when to take gains and losses.
- Tax lot selling: Use specific lot accounting to help minimize capital gains realizations. By selling shares with the highest basis first, investors may minimize capital gains.
- Buy and hedge: Use tax-advantaged hedging techniques as alternatives to taxable sales in order to manage gains and losses, potentially maximizing after-tax returns.
- Ladder a municipal bond portfolio: A professionally managed laddered portfolio can offer meaningful advantages over self-managed portfolios. In addition to seeking tax-free income, investors may be able to minimize the impact of rising interest rates.
- Charitable gifts: High-income earners frequently donate to charity in order to lower taxes. Rather than cash, investors may want to consider using appreciated shares as a charitable gift.
Make taxes less taxing
Along with inflation and other factors, taxes can present a formidable risk for investors seeking to protect and grow their wealth. Exacerbating the risk these days, taxes have risen for many investors and may rise further in the period ahead.
In this challenging environment, it is critical that investors understand the potential impact of taxes on their portfolios. Appropriate strategies to help mitigate the “tax drag” should be explored. By pursuing a sound, tax-aware investment approach, both high-net-worth and less affluent investors may be able to optimize the likelihood of reaching their long-term goals.
About Asset Class Comparisons
Elements of this report include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.
The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risks and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging-market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.
Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially, depending upon specific investment vehicles chosen. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes, except U.S. Treasury securities (exempt from state and local income taxes) and municipal securities (exempt from federal income taxes, with certain securities exempt from federal, state and local income taxes). In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.
About Risk
Municipal securities are subject to the risk that legislative changes and local and business developments may adversely affect the yield or value of the securities. They are also subject to credit risk, meaning an issuer could default on interest or principal payments, and interest-rate risk. Rising interest rates could reduce the value of bonds in the portfolio. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. A portion of municipal income may be subject to federal, state and/or local income taxes, and may also be subject to federal alternative minimum tax. There generally is limited public information about municipal issuers. Investments in municipal and other income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer’s obligation in the event of nonpayment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher-rated investments. Equity investing involves risk, including possible loss of principal. Investments in equity securities are sensitive to stock market volatility. The ability to utilize various tax-managed techniques may be curtailed or eliminated in the future by tax legislation or regulation. Market conditions may limit the ability to generate tax losses or to generate dividend income taxed at favorable tax rates. There is no assurance or guarantee that any company will declare dividends. There is also no assurance or guarantee that, if declared, dividends will remain at current levels or increase over time. No Fund is a complete investment program, and you may lose money investing in a Fund. A Fund may engage in other investment practices that may involve additional risks, and you should review the Fund prospectus for a complete description. There is no assurance that the objective of any investment strategy will be met. Diversification cannot ensure a profit or eliminate the risk of loss. Past performance is no guarantee of future results. Indexes are unmanaged. It is not possible to invest directly in an index.
Eaton Vance does not provide tax advice. This material is not intended to act as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel prior to investing.
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