With tax season upon us, savvy investors will once again be reviewing the tax efficiency of their retirement portfolio. For many the tax pain caused by the changes under the American Taxpayer Relief Act (ATRA) is still fresh in their mind. ATRA not only increased the top income tax rates but also reduced the value of certain tax expenditures such as itemized deductions, personal exemptions and tax credits for some taxpayers.
But for many, the biggest tax increase was on their investment income. ATRA increased the tax rates for long-term capital gains and qualified dividends from 15% to 20% for those in the top tax bracket. In addition, many are now subject to the 3.8% Medicare surtax introduced as part of the Affordable Care Act in 2013. An annual portfolio review may unveil certain tax inefficiencies and help investors mitigate the tax pain felt last April.
Many people don’t think about how taxes could affect their long-term investment and retirement goals. The taxes an investor pays annually on capital gains, dividends and interest could significantly erode a portfolio’s return in the future. Morningstar measures the tax cost ratio of most mutual funds, and while some funds will have a low tax cost ratio, other funds can have ratios as high as 3% or more each year. This means that a mutual fund with a 2% tax ratio will surrender 2% of its returns to taxes each year. The tax drag will be greater for those funds that are actively managed and have a high turnover ratio.
The turnover ratio of a mutual fund is measured as a percentage of the fund’s holdings that have been sold and replaced during the prior year. For example, if a mutual fund invests in 100 stocks and 50 of them are replaced, the fund would have a turnover ratio of 50%. The average actively managed fund has a turnover ratio of nearly 90%. Because the fund’s holding period was less than one year, this could result in a lot of short-term capital gains being distributed to the investor each year. This is true even if the fund loses value. In the current tax environment, that means those short-term capital gains can be taxed at a rate as high as 43.4%.
Large capital gain distributions from mutual funds have compounded the tax problem for many. Taxable distributions from mutual funds have increased each year since the recession of 2008. Eighty-four percent of funds, both active and passive, made a capital gain distribution in 2014. Nearly one quarter of those funds made a distribution of 13% of its net asset value (NAV) or greater. The average mutual fund had an 8.97% distribution as a percentage of NAV. The reasons for the increased taxable distributions are likely due to several factors including a six-year bull market, losses from the 2008 recession which have since been absorbed to offset gains, increased market volatility, fund managers forced to sell underlying investments due to increased fund redemptions, and a fund’s change in investment strategy. In addition, periodic rebalancing of a taxable portfolio to maintain proper asset allocation will cause further drag on investment returns.
Of course, investors cannot eliminate all investment-related taxes, but they can consider options to limit them and improve a portfolio’s efficiency. To that end taxpayers may want to ask themselves these questions:
- Did you pay higher taxes on investment income last year?
- Were you subject to the 3.8% Medicare surtax?
- Are you invested in high turnover mutual funds?
- Did you receive a 1099 last year even though you didn’t sell the investment?
- Did you pay taxes when rebalancing the asset allocation of your portfolio?
- If the investments are for retirement, are you paying taxes on income that will be used in the future?
The investor may also want to consider whether they had large numbers in the following lines of last year’s personal income tax return.
- Line 8a: Taxable Interest
- Line 9a: Ordinary Dividends
- Line 13: Capital Gains
The benefits of tax efficiency, tax diversification and tax deferral become more compelling in a changing and potentially rising tax environment. Consideration may be given to the benefits of investment-only annuities. These products allow investors better control over current taxes, tax-free portfolio rebalancing and the ability to defer taxation on retirement income until the income is actually needed. While traditionally thought of as a vehicle to help protect high-income clients, it is important to note, tax deferral benefits investors of all income levels. In fact, for lower- to middle-income taxpayers, deferring gains and income on assets can have ancillary benefits such as reducing a client’s Social Security taxes and healthcare costs. One thing to keep in mind is that tax-deferred accounts are subject to ordinary income tax upon distribution, which can substantially lower the final value of the account.
Rising taxes will have greater influence on investor behavior. Taxes erode portfolio returns. Tax diversification and product allocation will likely be as important as investment diversification and asset allocation in the future. It may be a good time for investors to review strategies to reduce current taxes and improve the tax efficiency of their portfolio.
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