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