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Give your portfolio a tax break

Taxes can be complicated, but consider these three simple steps to minimize taxes on your investments


  1. Invest as much as you can and is allowed by law in a tax-advantaged account such as a 401(k) or an IRA.
  2. Look for mutual funds that are tax-efficient when you're investing in taxable accounts. Examples include tax-managed funds and stock index funds that typically have minimal taxable distributions.
  3. Avoid too much trading activity, because it can trigger short-term capital gains taxes.

In this seven-minute video, Vanguard tax expert Joel Dickson shows you how these straightforward approaches can help you earn better after-tax returns.

How to improve your after-tax returns

March 11, 2009 | Joel Dickson, Vanguard Quantitative Equity Group
 
 
 

TRANSCRIPT

 

Joel Dickson: As a mutual fund investor, you know that you can't control the ups and downs of the markets, but there are many things you can do to increase your chances of reaching your financial goals.

One significant way to help your bottom line is by being a tax-smart investor. That means seeking to maximize what you keep after taxes without taking any unnecessary risks. The payoff can be sizable. Being tax-efficient has the potential to boost your return significantly over the long term, all other factors being equal.

Let's start with one of the most powerful things you can do to maximize the chances of helping your after-tax returns. If your employer offers a retirement account, such as a 401(k) or 403(b) plan, you should consider investing as much as you can in the plan. This is especially important if your employer matches any part of your contribution to the plan. That employer match represents an immediate increase to your contribution. Also, consider contributing on your own to a Roth IRA where your money can grow tax-free, or a traditional IRA where it can grow tax-deferred.

This chart [which appears in the video] shows the powerful effect of accumulating money without worrying about taxes. You can see that the tax-deferred investment can potentially grow much more than the taxable account, and this example is based on today's tax rates. The tax-deferred account would enjoy a greater advantage if tax rates are raised to the level they were back in the early 1990s. Tax rates can change at any time, of course, and if they do go up, it may be even more beneficial to invest as much as you can in a tax-advantaged account.

Next, you may find it beneficial to your bottom line by using different types of funds for your taxable versus your tax-deferred accounts. For example, broad-based stock index funds, tax-managed funds, and municipal bond funds often have some tax advantages that typically work better in taxable accounts. Funds that have the potential to pay out more in taxable distributions, such as actively managed stock funds that may generate higher distributions of dividends and capital gains, often work better in a tax-deferred account. The same is true for taxable bond funds. Holding these investments in a tax-advantaged account allows you to reinvest distributions without paying taxes on them when you receive them.

This kind of smart asset location can also help keep more of your returns after taxes over the long term. For your taxable accounts, you can still reduce the potential tax bill on your investments if you look for funds with certain characteristics. For example, a stock fund that doesn't buy and sell stocks too frequently, such as an index fund, is less likely to realize and distribute capital gains. Lower distributions can mean a lower tax bill for you.

Another way a fund can be tax-efficient is by using certain techniques to select which securities to sell. For instance, Vanguard offers a series of funds called tax-managed funds that specifically seek to minimize capital gains distributions through these techniques. If you're seeking income from a bond fund and you're in a higher income tax bracket, you can consider a municipal bond fund because its income distributions are generally exempt from federal income tax. But if you're not in a higher tax bracket, you may still receive more income from a taxable bond fund even after you've paid income tax. So check the math to see what's best for you on an after-tax basis.

Besides picking tax-efficient investments, there are other things you can do to reduce taxes on your investments. For example, if you don't buy and sell too often in taxable accounts, you lower the risk of realizing profits that are subject to capital gains taxes. As long as you buy and hold an investment, you generally won't have to pay taxes on its rising value.

Here's a hypothetical example of how tax efficiency may benefit you in a taxable account. You'll see [in the chart appearing in the video] that a stock fund that's tax-inefficient—that is, it pays higher distributions—can generate a higher return if the investor buys and holds the fund rather than selling it every three years to buy a similar fund. Now notice how a fund that has lower distributions can provide a higher after-tax return than the inefficient fund, although, as you can see, trading every three years reduces the after-tax return significantly. The buy-and-hold investor has the advantage in both cases, and even the buy-and-hold investor with the tax-inefficient fund does better than the investor who owns a tax-efficient fund but trades it every three years for another one.

So, to wrap up, remember these three keys to seeking higher after-tax returns. First, and most important, consider investing as much as you can in tax-deferred accounts. If you have extra money to invest, the next most important thing you can do is consider funds with lower distributions for your taxable accounts. And, finally, be tax-efficient yourself by avoiding too much trading activity. Of course, everyone's situation is different and tax laws may change, so you should consult your tax advisor.

Thanks for watching.

For more information about Vanguard funds, visit Vanguard.com or call 800-662-2739 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

It is possible that Vanguard Tax-Managed Funds will not meet their objective of being tax-efficient.

Investments are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market.

Past performance is no guarantee of future returns.

For the first bar chart, the calculations are based on an 8% annual return. Each investment distributes 1% of its net asset value annually as a short-term gain and 2% as a long-term gain. Returns from the taxable account are subjected to a 35% tax rate on short-term capital gains distributions and a 15% tax rate on dividend and long-term capital gains distributions. No state and local taxes were considered. At the end of the 30-year period, both investments are liquidated. The withdrawal from the taxable account is subjected to a 15% capital gains tax rate, while the withdrawal from the tax-deferred account is subjected to a 35% income tax rate. For the second bar chart, the calculations are based on an 8% annual pre-tax return and a 2% dividend yield. The tax-efficient fund distributes no short-term or long-term capital gains annually. The tax-inefficient fund distributes 1% of its net asset value annually as a short-term gain and 2% as a long-term gain. After-tax returns are calculated assuming a 35% tax rate on short-term capital gains distributions and a 15% tax rate on dividend and long-term capital gains distributions. These returns do not reflect the impact of state and local taxes. The buy-and-hold returns assume that the investment is not liquidated at the end of the investment horizon.

We recommend that you consult a tax or financial advisor about your individual situation.

NOTES:

  • All investments are subject to risk.
  • It is possible that Vanguard Tax-Managed Funds will not meet their objective of being tax-efficient.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Diversification does not ensure a profit or protect against a loss in a declining market.

 

 

 
 
 
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