Tax efficient investing is an important but overlooked concept to becoming a successful investor. One of the greatest investors of all time, Sir John Templeton, said, “For all long-term investors, there is only one objective, maximize after tax returns.”
How big of an impact do taxes really have? One study by Alliance Bernstein measured the impact of taxes. The study showed that the average pre-tax return from Domestic Large-Cap funds from a 15-year period ending June 2003 was 10%. However, after taxes those funds returned only 7.7% for investors. Therefore, $10,000 invested would only be worth $30,430 after-taxes instead of $41,770 pre-tax after 15 years. More than a 25% reduction in returns!
The purpose of this page is to give you an understanding of the impact of taxes on your investments and specific strategies and resources to maximize your returns.
Tax Terms
Before going forward, you need to understand common tax terms:
- Bond Dividends – Interest received from your bond investment, which is taxed at your marginal tax rate.
- Capital Gains – Your profit from an investment.
- Long-Term Capital Gain – A long-term gain is realized after selling an investment that was held for greater than one year. Long-term gain taxes are more favorable than taxes on short-term gains.
- Short-Term Capital Gain – A short-term gain is realized once you sell an investment that was held for less than a year. Short-term gains are taxed at ordinary income tax rates.
- Cost Basis - The investments original value.
- Realized Gain/Loss – The gain or loss from an actual sale of an investment.
- Stock Dividends – Payments from profits paid to shareholders.
- Fund Turnover - The percentage of the mutual fund’s holdings that change during the year.
Tax Efficient Investing – Taxable Equivalent Yield
The next step tax efficient savings is knowing your taxable-equivalent yield.
The chart below shows before and after tax returns of a 7% and 10% pre-tax investment depending on your tax bracket.
This is useful when deciding between a tax-free investment and a taxable one. For example, if you’re in the 25% tax bracket, a taxable investment that pays 10%, has a greater after tax-return than a tax-free investment that pays 7%. However, if you’re in the 33% tax bracket, the tax-free investment would have a better after-tax return.
| 2009 Tax Bracket | 7% Return | 10% Return |
|---|---|---|
| 10% | 6.3% | 9.0% |
| 15 | 5.95 | 8.5 |
| 25 | 5.25 | 7.5 |
| 28 | 5.04 | 7.2 |
| 33 | 4.69 | 6.7 |
| 35 | 4.55 | 6.5 |
Equation for taxable equivalent yield:
Taxable Equivalent Yield = Pre-tax returns x (1 – marginal tax rate)
*Please note this example didn’t include state income tax.
How Are Mutual Funds Taxed?
I’m a firm believer that most of our investments belong in mutual funds. The fund industry has created a fund for your situation no matter your time horizon or risk tolerance,
There are three possible ways to profit, which means there are 3 ways you’re taxed, by owning a mutual fund:
- Dividend Payments — If the fund’s holdings pay dividends or interest, the fund itself receives these payments and pays them out to each shareholder. For example, if you own the S&P 500, and Microsoft, whose stock you own by investing in the S&P 500, issues a $2 per share dividend payment. The dividend first goes to the mutual fund, and then is distributed to you.
- Capital Gains Distributions — The manager of your mutual fund could sell a stock he held for a capital gain and reinvest it into another stock. At the end of the year, the mutual fund than pays out the capital gain to shareholders. For example, you owned an actively managed mutual fund. The manager sells Apple stock at $100, that he originally bought for $50. The mutual fund has a capital gain of $50.
- Increased Net Asset Value or NAV - The market value of your mutual fund will go up or down depending on the performance of the stocks inside. If you sell the fund for more than you paid for it, you have a capital gain.
Fairmark has an excellent guide to mutual fund taxation.
10 Tips for Tax Efficient Investing
If you understand how mutual funds are taxed, you can invest tax efficiently by:
- For any goal beyond 59 1/2 max out tax-deferred accounts like 401K’s and IRA’s.
- For long term goals outside of retirement accounts, use an index fund or tax-managed fund.
- To avoid short-term capital gains, don’t rebalance more than once inside of a 365 period.
- Realize a capital gain in January rather than December to defer taxes one more year.
- Realize a capital loss in December rather than January to offset any gains.
- Tax loss harvest
- Put tax efficient investments like stock index funds outside of retirement accounts, and put tax-inefficient accounts like bonds inside of retirement accounts.
- Pick funds with low turnover. Less than 5% is preferable. Funds with no turnover have little capital gain distributions.
- Knowing the distribution date. This is where it helps understanding what a mutual fund’s net asset value is. For example, you invest $1,000 on Thursday, December 14. The fund’s NAV is $50. You now own 20 shares. On December 15, the fund pays a distribution of $5 ($100 total) per share, which you reinvest, buying two more shares. Your investment is still worth $1,000 but you own 22 shares, and you will have to pay tax on the $100 distribution even though you held that fund for only one day! In this example, an investor would have been better off buying on December 16.
- Invest in funds with qualified dividends Most domestic funds dividends are qualified, while some international funds dividends might not be. The information for previous year’s dividends can be found in the fund’s prospectus.
When discussing taxes, it’s important to understand that laws vary by state. This post was just a general outline of tax on the impact of taxes on your returns. Your individual situation may differ.
Taxes can be a very complex subject. If you have any questions let me know in the comments below. If you have more interest in this subject here are a few resources:
- The Importance of Tax Efficient Investing
- How To Create A Tax Efficient Portfolio of Investment
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