(Corrects Medicare surtax figure in fourth paragraph to 3.8
By Linda Stern
WASHINGTON Jan 23 Experienced money managers
like to say you shouldn't "let the tax tail wag the investment
dog," meaning you shouldn't let concerns about the tax effects
of an investment drive your buy and sell decisions.
That is probably good advice, but still -- in this post
"fiscal cliff" era of higher income tax rates and new healthcare
reform-driven investment taxes, it makes sense to at least look
at the tax impact of your savings choices.
"A good financial planner should be looking at how
tax-efficient your investments are," says David Blanchett, head
of retirement research for Morningstar Investment Management. He
points out that the difference between having a $1,000 gain
taxed at the long-term capital gains rate of 20 percent versus
the income tax rate of 35 percent would save the investor $150.
And that example doesn't even use the top income tax rate or
note that other new provisions could hit investment income as
Upper-income households at several different levels face
higher tax burdens this year. Individuals with adjusted gross
income over $200,000 ($250,000 for joint-filing couples) will
face a 3.8 percent Medicare surtax on investment income. Singles
who earn over $400,000 (joint filers over $450,000) will face a
new top marginal tax bracket of 39.6 percent. Those same people
will see their tax rates on dividends and long-term capital
gains go up to 20 percent from 15 percent. And limits on
itemized deductions and personal exemptions will start to kick
in on incomes over $250,000.
That all points to at least considering the wagging tail
before you buy the dog. In addition to being taxed itself,
income from investments could push investors into higher tax
brackets, so minimizing taxable income could be an especially
good idea for investors on the cusp of higher brackets. And some
tax-smart investments actually perform better than their
Take tax-efficient mutual funds, for example. These funds
are actively managed to minimize the taxable income they
produce. Their managers sell losing securities, match up losses
and gains, hold stocks at least a year so that their gains count
as long-term, choose stocks that don't produce a lot of taxable
dividends, and try to keep taxable transactions low. That's
particularly important for mutual funds, because they are
required to distribute dividends and capital gains to
shareholders annually. So, even shareholders who keep a fund for
decades will usually receive taxable contributions annually
along the way.
These tax-managed mutual funds have a pretty good record of
outperforming their non-tax-managed competitors on an after-tax
basis, according to new research from Lipper, a Thomson Reuters
Lipper analyst Tom Roseen compared the after-tax performance
of every major tax-managed mutual fund with the average
after-tax performance of its whole category. "Tax-managed funds,
on average, did a fine job," he said. For example, over the 10
years ended Dec. 31, 2012, the tax-managed large cap core stock
funds returned an annual average of 5.82 percent after taxes.
The entire category (which includes hundreds more funds)
returned 5.71 percent after taxes.
"In only six classifications of 20 did they not outperform
their category average, and that is a pretty strong statement,"
But both Roseen and Blanchett stressed that not every fund
is a winner, and there are other ways to minimize the tax hit on
investments. Here's how to approach that.
-- Be picky. Look at a fund's total return and its tax
efficiency. Consider how it performs after expenses. Lipper
offers performance and tax-efficiency ratings for funds at www.reuters.com/finance/funds.
Morningstar (www.morningstar.com) has a measure called
"tax cost ratio" -- the amount of a fund's annualized return
that is lost to taxes paid on distributions.
-- Look at less managed alternatives. An active fund manager
who's keeping one eye on the tax bill can produce solid low-tax
returns, but you will have to pay for him. An exchange traded
index fund (ETF) can be very competitive on performance, tax hit
and bottom line cost, for a variety of reasons. Index funds tend
to be low-turnover so they generate a low tax hit. ETFs don't
have to buy and sell stocks to accommodate buying and selling
shareholders (as mutual funds do) so they can hold onto their
portfolios even longer. And, as low-trading, unmanaged index
funds, ETFs keep expenses rock bottom.
Will an active manager beat an ETF by enough to justify her
fees? Sometimes yes, and sometimes no. That's a question of
investment philosophy that chartered financial analysts can
spend their entire careers trying to answer, so it's OK to
answer for yourself.
-- Run your own fund. It's not for everyone, but at least
two online brokerage firms specialize in putting together
pre-set portfolios for investors who would rather own pieces of
individual stocks instead of a fund. You can use them to get the
diversity of a mutual fund without the complicated tax structure
and extra layer of management fees.
That sounds complex, but at Motif Investing Inc (www.motifinveseting.com)
and Foliofn Investments Inc (www.folioinvesting.com) you
can buy a fixed portfolio for a low fee. Because investors end
up owning fractional shares of individual stocks, there are no
capital gains distributed annually, as there would be from a
mutual fund. Both sites let you manage the portfolios for
maximum tax advantage by selling individual stocks to lock in
-- Placement matters, too. Tuck those high income-producing
investments inside your tax-advantaged 401(k) or Roth IRA. Use
your taxable account for the low-tax-hit choices like ETFs,
tax-managed mutual funds, and portfolios of individual stocks,
or pieces of them.
(Linda Stern is a Reuters columnist. The opinions expressed are
her own. The Stern Advice column appears weekly, and at
additional times as warranted. Linda Stern can be reached at
email@example.com; She tweets at www.twitter.com/lindastern
.; Read more of her work at blogs.reuters.com/linda-stern;