Why it's important to be a tax-efficient investor
June 11, 2013
Rebecca Katz: Joel, we'll come to you first with a question. Let's talk about this concept of maximizing after-tax returns. What does that really mean for us as investors?
Joel Dickson: Well, actually I want to describe that by, if we can, putting up a visual that we have describing different ways that people think about building portfolios from an after-tax basis. And I think the most important thing to consider is that it's not about minimizing taxes necessarily: It is, as you said, Rebecca, about maximizing after-tax returns. And the key way or the best way in many cases to maximize after-tax returns is actually to maximize your tax-deferred account contributions and opportunities. It might be an IRA or a 401(k), a college savings plan, but tax-preferenced accounts—even though you're not paying taxes and people don't necessarily think about it as "I'm being tax-efficient because I'm not worrying about the tax piece of my portfolio"—but in fact, having as much in tax-deferred opportunities as possible is a really good way to maximize that after-tax return.
As this example shows there's—and just to set it up a little bit, the example assumes a $5,000 annual contribution on a pre-tax basis over a 30-year period with a 7% return, 25% tax rate—and you can see that the biggest difference in the height of the bars comes from the tax-deferral options of the IRA, versus non-deductible contributions or taxable account investments in the other three cases.
Rebecca Katz: I see. Well, we're going to come back to that topic in a little bit with a polling question, but let's see if we have the results of our first poll. Let me take a look. We talked about "how confident are you that your investment portfolio is tax-efficient," and actually a good number of our viewers are fairly confident. We have 51% of viewership saying they're "somewhat confident" and another 18% saying they are "very confident," so the majority feels pretty good. Hopefully we'll be able to give you some further tips during this webcast, or at least test whether or not you are, in fact, tax-efficient within your portfolio.
So Maria, Joel touched on this idea of maximizing IRAs, 401(k)s; I didn't know if you wanted to talk about that a little bit further or if there are other ways of being tax-efficient within your portfolio.
Maria Bruno: I think Joel's point was very relevant. I mean, you can't avoid taxes, right? We can't. The best you can do is manage that, and I think you can do that in one of two ways. One would be to think about what type of accounts to invest in. As Joel had mentioned, one way to do that is to maximize tax-advantaged accounts. And then—I think we'll talk a lot about this today—is once you establish your accounts, how do you allocate? So, you know, how do you put the puzzle together in terms of investment selection? Those two decisions come together and really serve as the basis for tax-efficient investing.
Rebecca Katz: I guess I would put this question to you. We talked about not trying to avoid taxes; what are some of the big mistakes that investors make when they do seek to do that first?
Maria Bruno: Sometimes it's "kick-the-can-down-the-road" with taxes, right? I don't want to pay taxes today; I'll defer this and pay it later. Because it's natural not to want to pay income taxes today. It's human nature; none of us enjoys paying taxes really, but that's not necessarily the best thing. So it's really trying to understand: okay, the reality of it is there are going to be either capital gains taxes or income taxes at some point on some of this, so how do I manage my current tax liability, understanding what the implications are down the road?
Again, we don't have a crystal ball; we don't know what the future tax regimes will look like. But what we can do is look at what the current tax structure looks like and try to have balance, for instance, between accounts. We'll probably talk about this today in terms of tax diversification. Much like [with] asset allocation, we hold different types of asset classes to try and weather out the different market cycles. The same thing with tax planning and accounts; holding different types of accounts so that you have the most flexibility down the road, regardless of what the tax regime looks like. Having that dual lens is really a good approach.
Joel Dickson: I think the other thing that people really have to think about, in tax-efficient investing in their overall portfolio, is [that] it's just as important to focus on your own behavior as well as the behavior of the portfolios or the funds that you're using. And the way I like to talk about it is [that] it's not enough to just select tax-efficient investments. You also have to be a tax-efficient investor. And so if you have these tax-efficient investments, and then you sell out of them three years down the road, well, okay, maybe you didn't pay capital gains from the underlying investments, but then you generated possibly capital gains in your own activity and undid all of the tax effects that you were trying to capture. And tax effects, like other cost-type issues, tend to compound or have a better chance at seeing greater value over longer holding periods, longer periods of time.
Rebecca Katz: Right, especially when tax rates decline for holding them longer.
Maria Bruno: And it's important to be tax-sensitive throughout. So when you're rebalancing, for instance, if you're drawing assets, even tax-loss harvesting, to the extent that you need to sell items, you can be tax-savvy as best as you can with these types of implementations.
All investments are subject to risk, including the possible loss of the money you invest.
For more information about Vanguard funds, visit Funds, Stocks & ETFs or call 877-662-7447, 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.
When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
We recommend that you consult a financial or tax advisor about your individual situation.
© 2013 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
Put your assets to work for you
You can't always avoid paying taxes but you can manage their impact on your investments. Joel Dickson and Maria Bruno of Vanguard's Investment Strategy Group emphasize the importance of tax-deferred accounts, and caution that how you buy and sell investments also can affect your after-tax returns.
Other excerpts from this webcast:
- All investments are subject to risk, including the possible loss of the money you invest.
- For more information about Vanguard funds, visit Funds, Stocks & ETFs or call 877-662-7447, 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.
- When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- We recommend that you consult a financial or tax advisor about your individual situation.