When tax time comes again, can your portfolio cost you less?
August 18, 2014
Few things are certain in the world of investing, but taxes are one of them. And this time of year—roughly halfway between April 15 and the beginning of next year's "tax season"—is as good a time as any to think about how big a bite they can take out of your investment returns.
John Kilroy, a senior financial planner at Vanguard, notes that some of the pain can be averted through prudent choices about "asset location." That means deciding which types of assets to put into taxable accounts and which to keep in tax-advantaged accounts, such as 401(k) plans and IRAs, to obtain the highest after-tax returns.
"As an investor, you naturally want to keep as much of your investment returns as possible," said Mr. Kilroy, "but if you're not paying attention to asset location, you're probably giving up more of those returns to taxes than you may otherwise have to."
A key reason asset location is important is that, from a tax perspective, not all investment returns are created equal. For buy-and-hold investors, the bulk of the total return for money market and bond funds generally comes from interest payments. If these securities are not tax-exempt and are held in a taxable account, the income they produce is taxed as ordinary income at an investor's federal income tax rate, which can be as high as 39.6% this year, and other taxes may apply as well.
Especially over time, that can add up to a large portion of your total return; that's why these investments are labeled tax-inefficient by financial planners, who typically suggest putting them into a tax-advantaged account. If that account is a 401(k) or a traditional IRA, you'll eventually owe ordinary income tax when you withdraw the money; until then, all your pre-tax returns can be reinvested to compound over time.
Compare that with an investment in a broad stock index fund. The majority of its return over time comes from price appreciation, which is taxed as a capital gain. If you have held the fund for more than a year, the return is considered a long-term capital gain; that makes the investment tax-efficient, as the tax rate would be 20% or less, depending on your income. The same rate would apply to qualified dividends that the fund might produce.
Mr. Kilroy explained: "If you put a stock fund into a tax-deferred account, you are agreeing to make a trade. You could have had that fund in a taxable account and paid a long-term capital gains rate if you held it for more than a year, but in a tax-deferred account, you will pay the ordinary income rate when it is withdrawn. And that's not in your favor."
A hypothetical example illustrates the point: Taking a $1,000 profit from the sale of shares in a stock fund held in a taxable account may net even a very high earner $800 after federal income tax is paid. But if that stock fund were held in a tax-deferred account, that same transaction would ultimately net the investor $604 or less under current tax rates. (Note that other taxes, including state income taxes, may also diminish what an investor may retain.) "Managing with an eye on taxes really is important," said Mr. Kilroy, "because, in the end, it's not the amount of assets in your accounts that matters—it's the amount of assets in those accounts that you get to keep."
Paying heed to asset location
Not sure of where to put what? Here's a rule of thumb for funds:
|Taxable accounts||Tax-advantaged accounts|
|Broad-market stock index funds
||Taxable bond funds
|Tax-managed stock funds
||Actively managed stock funds
|Tax-exempt municipal bond funds
||Real estate investment trust (REIT) funds
- All investing is subject to risk, including the possible loss of the money you invest.
- We recommend that you consult a tax or financial advisor about your individual situation.