Taxing Matters

Jonathan Clements

IF YOUR GOAL IS lower investment costs, the financial world has never been friendlier. Let’s say you want to buy the broad U.S. stock market. You can choose between a Schwab exchange-traded index fund that charges 0.03% of assets per year, an iShares ETF that levies 0.03% or a Vanguard mutual fund that costs 0.05%.

Those expense ratios are truly astonishing: If you had $100,000 to invest in the broad U.S. market, your annual fund expenses would be just $30 or $50. Sure, it would be nice if it was $20. But with expenses already so low, it won’t make much difference to your long-run wealth. My contention: For cost-conscious investors, the fund battle has been largely won—and today’s focus should be less on saving an additional 0.01% and, instead, we should devote our energies to the biggest investment cost of all, which is taxes. To that end, here are five rules for managing your portfolio:

1. Aim for 5% Turnover

Suppose you own a stock fund with 100% turnover, which implies it’s hanging on to its positions for 12 months, on average. Not only does that mean big immediate tax bills as the fund quickly realizes its gains, but also some positions may be held for a year or less, so they’re taxed at the income-tax rate, rather than at the lower capital-gains rate.

Sound bad? A fund with 50% turnover might seem like a big improvement. But in fact, the fund is holding its positions for two years, on average, which means the tax hit is barely postponed. Instead, if you want meaningful tax deferral, you need turnover of 5% or less, which translates to a holding period of 20 years or more. That will allow you to postpone the taxes owed to Uncle Sam and, in the meantime, use the money to earn extra gains for yourself.

The good news: Many index funds have turnover of 5% or less. The bad news: Many investors take this advantage and squander it, by holding their index funds for just a few years and thus inflicting large tax bills on themselves.

2. Location, Location, Location

Rule No. 1 is crucial for those investing through a regular taxable account. What if you lean toward funds that trade heavily or you trade heavily yourself? Reserve this frenetic activity for your retirement account, where you can buy and sell to your heart’s content without triggering a tax bill. A retirement account is also the best place to hold taxable bonds and real estate investment trusts, both of which can generate lots of immediately taxable income.

Meanwhile, think carefully about the investments you purchase in your taxable account. I would focus on U.S. and international total stock-market index funds. You should be happy to hold these total market funds for decades and decades. With almost any other stock investment, you’ll either get slapped with big tax bills or, alternatively, you could be compelled to sell by poor performance or lack of diversification—which could also trigger a tax bill.

3. A Roth Isn’t Always Right

I’m a big fan of Roth 401(k) plans and Roth individual retirement accounts, where you give up the chance for an initial tax deduction, but in return enjoy tax-free growth.

In particular, I think the Roth is a great option for those who are new to the workforce, because often they’re in a low tax bracket and hence the tax deduction for funding a traditional retirement account won’t be especially valuable. I also think converting part of a traditional retirement account to a Roth can be a smart move for those who find themselves with a year with relatively little taxable income.

But for most folks, a traditional tax-deductible 401(k) or IRA will be the right choice. Why? When you fund these accounts, the tax deduction trims your tax bill by reducing your taxable income. Without that deduction, the income involved would be taxed at your marginal tax rate, which might be 25%.

Now, fast forward to retirement. Let’s assume that your retirement account withdrawals are your only taxable income and that you’re still in the 25% marginal tax bracket. That means part of your retirement account withdrawals will be taxed at 25%, which is the same as your initial tax savings—and thus it might appear as though there’s no net tax benefit.

But remember, before you get to the 25% rate, part of your retirement account withdrawals will be taxed at 0% (thanks to personal exemptions and standard or itemized deductions), 10% and 15%, so your average tax rate will be substantially less than 25%—and hence the average rate on your withdrawals will be substantially below the tax rate at which you took the initial tax deduction. One wrinkle: Those traditional retirement account withdrawals could trigger taxes on your Social Security benefit, so the effective tax rate on your withdrawals may be higher than the above example suggests.

4. Tax Losses Are Oversold

If you sell a losing investment in your taxable account, you can use the loss to offset realized capital gains and up to $3,000 in ordinary income. That’s a pretty sweet deal.

But keep three caveats in mind. First, while taking tax losses has great value for those in high tax brackets, the value is more modest for those in the 10% or 15% tax brackets. Second, frequent large tax losses are a sign that all may not be well with your investment choices. Third, if you’re a prudent buy-and-hold investor, the chance to take tax losses will likely disappear within a few years, as your investments appreciate.

5. Zero Is a Mistake

Every so often, I hear folks boast that they had a year when they paid no taxes—and all I can think is, “What a waste.” If you have a year with little or no taxable income, you should seize the opportunity to convert part of your traditional IRA to a Roth or sell winning investments in your taxable account that you’ve been looking to unload.

Your goal: to smooth out your taxable income over time, so you stay fairly consistently in the same marginal tax bracket. That’s preferable to paying zero tax one year and ending up in a high tax bracket the next year. A high tax bracket not only means punishing tax rates, but also you could see your itemized deductions and personal exemptions curtailed. On top of that, you might be penalized in other ways, such as paying more for Medicare or losing the tax credit that can help offset the cost of insurance bought through a health-care exchange.

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