Tax implications of active money management (part 2 of 2)

In the second part of this report, we'll discuss tax-advantaged accounts and specific investment products that can help minimize your tax liability. The most popular of all tax-advantaged accounts is the 401(k), named after the eponymous subsection of the Internal Revenue Code. The primary benefit of this account is the deferral of income taxes, as any dividends, capital gains, and a portion of your wages are not subject to current taxation. And when you do decide to distribute some of the funds for use—presumably during retirement—withdrawals are taxed at ordinary income rates, albeit at a rate which is most likely lower than during your peak earning years.

Contributing to a 401(k) plan also lowers your current tax burden because pre-tax amounts reduce your total taxable income for the current year. For example, if you’re in the 25% income tax bracket, a $10,000 contribution will save you $2,500 for the year in taxes you’d otherwise be paying to the government. It pays to save using a 401(k). And if your employer matches the annual contributions you make to the plan, it’s almost sacrosanct to disregard the benefits of such a plan.

It’s been estimated that an investor who utilizes a 401(k) and defers all gains (at a 10% annualized rate) over a 30-year period will come out, on average, $75,000 ahead of an investor who consistently pays taxes at a 20% rate year after year.1 There are many tax-advantaged accounts, from IRAs to Simplified Employee Pension (SEP) plans for self-employed individuals wishing to take advantage of tax breaks. The point is that by deferring the income you earn on your investments, you guarantee a higher return on investment than by recognizing it in a non-deferred account.

So now that you’ve set up a tax-advantaged account, which types of investments are good candidates for your money? The list of possible securities is overwhelming, which is why many people depend on someone they barely know to allocate their life savings: a major problem in and of itself.

Get on the ETF bandwagon

Two investment vehicles that are often used to generate returns for retirement—or any other long-term goal—are mutual funds and exchange-traded funds (ETFs). The main difference between the two is that ETFs tend to track an index, whereas mutual funds are expected to beat an index. Of course, if the mutual fund manager is paid to beat a particular benchmark index, like the S&P 500, they had better be actively trading to try and accomplish such a goal, despite nearly 80% falling short in any given year. So, we can safely say that more trading equals more taxes, thus giving ETFs a leg up on at least deferring some of the tax implications associated with investing. As an owner in an ETF, you’ll still have to pay Uncle Sam, but that usually comes when the underlying index is changed and the stocks that comprise it are sold.

Thus, the more active you are trading investments, the more active the government is collecting their share. To highlight just how active mutual funds have become, as of June 30, 2015, 84% of mutual fund assets were actively managed by an investment professional who is paid solely to beat a benchmark index. Contrast this with 99% of all ETF asset managers that recognize the futility of trying to beat an index and resign to simply tracking one; thereby guaranteeing their investors a return on par with the index returns, less expense ratio costs and other minimal fees to own an ETF.2

This is not to say that mutual funds don’t serve a purpose, there are many cases that would warrant an investment in a mutual fund over an ETF, especially if you’re looking to take more risk and attempt to outperform whatever index your fund manager is looking to beat, hopefully with a limited percentage of your portfolio. But with regard to tax implications, ETFs offer investors a means to limit their liability to the taxman. And when you utilize a tax-advantaged account with a tax-efficient investment, you get to keep more of your hard-earned dollars.

1.https://news.morningstar.com/classroom2/course.asp?docId=144042&page=4&CN=

2.https://personal.vanguard.com/pdf/ISGCETF.pdf

Tax implications of active money management (part 1 of 2)

When tax time comes, nearly everyone wants to minimize their tax obligation to the government. And they want to do it in the most economical way possible. The growth of online tax services will continue to grow as taxpayers have learned quite quickly that more traditional tax preparation services can be costly. Taxpayers want to legally keep every last dime from Uncle Sam, and they should. The average tax prep fee has been decreasing as the competition has only heated up over the past few years. Cost control is front and center when it comes to taxes, but seems to be nonexistent when investors decide to allocate their money in search of high returns. One of these costs associated with investing is often overlooked, even though it has consistently taken a bite out of returns. The tax implications of investing are a cost, and if you’re not careful, they can quickly add up.

U.S. equity funds that utilize an active strategy of investing lost about 1 percentage point on an annual basis to taxes over the 15-year period ending in September of 2014.1 A 15% loss on your capital is a substantial setback, and one that is completely avoidable. Decisions on where to put your hard-earned money shouldn’t be based entirely around the tax implications involved, but there needs to be an awareness of the tax costs, especially because this is a cost you can control, unlike the day-to-day fluctuation of the funds you’re invested in.

Churn and burn

There’s an illicit technique called churning that is sometimes used to generate cash for the not-so-ethical investment professional. It basically means that the person behind the desk managing your money is buying and selling securities at a rapid rate to generate commissions that will add to his or her coffers. It’s not commonplace, but it does happen. Needless to say, Mr. Money Manager is not picking up the tab each time a trade is made and a gain is realized. Nor are they likely to keep a running tab on those losses that may be eligible to offset capital gains or even ordinary income in any given year. Those recognized gains are a direct cost to the investor, and there’s no way to know how much it will cost you until the damage is already done. This, of course, is an extreme example, but nonetheless it highlights the fact that any fund manager who trades does not stand to lose a dime from those transactions—only the investor does. What’s more, when these fund managers report their annual returns, they do so before any tax costs are calculated; meaning you may think you’re getting a reported 8% per year, but in actuality, you may be receiving only 7% after taxes.

Thus, the more your advisor or broker churns, the more money of yours they inevitably burn. After all, inactivity in your portfolio means your taxes will be kept to a minimum. One interesting statistic is that on average, investment professionals employing an active investing strategy of trying to outperform their respective benchmark index will turn over about 85% of the holdings in their fund on a yearly basis.2 But one can hardly blame them because they’re paid to trade. If they simply did nothing, they’d be passively playing the market and hence not worth their weight in gold.

Become inactive

The best way to minimize your tax obligation is to invest in index funds. Because these funds track a benchmark index such as the Russell 2000, which is a small-cap stock index, the trading is minimal since the stocks included in the index are seldom added or eliminated. There will be some tax implications because turnover is not completely eliminated, but the cost savings for investors are far greater if index funds are used to construct your portfolio.

An ancillary benefit of passively-managed funds is that when it does come time for the manager to sell, most often the gains will be at the lower, long-term capital gains tax rate, as opposed to the short-term (and higher), ordinary income rate.

The key point to remember is that less is more when it comes to trading in and out of equities. Taxes are certain to reduce your overall returns, by how much is determined by you. In the next section of this two-part report, we will discuss tax-advantaged accounts and specific investment products that can be used to avoid a costly year-end tax bill.

1. Vanguard Research : Tax-efficient equity investing: Solutions for maximizing after-tax returns

2. http://www.fool.com/School/MutualFunds/Costs/Taxes.htm

Randomness

At the beginning of every year, you’ll find no shortage of pundits attempting to forecast the market for the ensuing twelve months. Each one has their own unique take on what they think will happen, despite the impossibility of actually being able to predict the future. But that’s what they’re paid to do, so one can hardly fault them for it. Upton Sinclair once said “it is difficult to get a man to understand something, when his salary depends upon his not understanding it.” Perhaps these market pundits are failing to understand that world events are random, and these events—to a large extent—drive the direction of the stock market. Therefore, it follows that the markets must be random, at least in part.

Figure 1 highlights just how random the market has been over the 15-year period from 1999 to 2013. Many have been fooled by the randomness of the market, and changes are often made to portfolios at precisely when a particular asset class has nowhere to go but up. For example, in 2008, during the Great Recession, the MSCI Emerging Markets Index lost more in that 15-year span than the other 10 asset classes represented in the figure, falling 53% in one year. If you had sold out at the bottom, thinking that the trend was going to continue into the next year, you would have lost on the 79% gain that followed the very next year; the biggest gain during that time period for any asset class.1 Our guess is that no pundit would’ve seen that coming.

Figure 1. Market returns by asset class, 1999-2013

Just as there is no discernible pattern to the MSCI Emerging Markets Index, the same can be said for the other 10 asset classes in the illustration. The S&P 500 Index, widely considered the market’s bellwether index for domestic equities, has had one-year swings in excess of 30%, 50%, and 63% over the 1999-2000, 2002-03, and 2008-09 periods, respectively. Some time periods of the S&P were in positive territory the first year before going negative the next, while some were deep in the red, like in 2008, subsequently reversing course and posting big gains the following year. The point is that no one knows what the market is going to do on a daily, weekly, monthly, or yearly basis. That’s not to say, however, that we can’t make educated guesses on what the market may do over longer time periods.

We wrote about the intricacies of long-term investing in an article entitled Allocating your hard-earned capital, the smart way. Our premise was that over long periods of time, a portfolio of all equities will yield higher returns than an all-bond portfolio, but with the additional risk of substantial volatility. If less volatility is desired, a portfolio more heavily weighted towards bonds would be more suitable. In other words, general trends over long periods of time do occur, but short-term, technical analysis of price movements in stocks are nearly impossible to anticipate ahead of time with any precision. Long-term trends are good guides by which to construct your portfolio, but only if you’re going to be a net buyer over that time period. If you’re looking to sell in the not-so-distant future, it’s best to preserve the capital you have by allocating more capital towards bonds.

In short, markets are random, leaving investors with limited information on where they will go next. By taking a step back and realizing that the market is much smarter than us, we can be better disciplined to take advantage of the randomness that surrounds us.

1.https://investor.vanguard.com/investing/investment-research