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.