TAKE NOTE: COVER STORY
Balance the impact of taxes with a strategic approach.
Look at the performance data for many mutual funds and you’ll see how well the fund has performed over various time periods. But such fund comparison data tell only part of the story: They represent that fund’s returns before taxes—and ignoring the impact of taxes is a potentially costly mistake. How costly? Taxes can weigh down your taxable portfolio’s return as much as 2% annually.1 That figure may not sound like much, but it can have a substantial impact over time. "If you ignore the implications of taxes, there may be a dramatic difference between what you could have earned and what you really earn at the end of the day," says Don Peters, portfolio manager of the T. Rowe Price Tax-Efficient Equity Fund.
Adopting a tax-efficient approach to your investment strategy can help reduce the drag taxes typically have on your portfolio. However, a tax-efficient strategy doesn’t seek to eliminate taxes altogether. Rather, this approach aims to maximize your after-tax returns. Choosing an investment strategy that works for your situation and provides tax efficiency can go a long way toward helping you achieve your financial goals.
THE COST OF TAXES
For individuals using a taxable account, a tax-efficient investment strategy may be an appropriate option. The real cost of losing two percentage points of return to taxes can amount to thousands of dollars over time in even a modest taxable account—a loss that can compound through the years. (See The Cost of 2% below.)
Many investors don’t think to adjust their investment strategy when switching from a tax-advantaged account to a taxable account. "When you are using a taxable account, you need to invest differently," says Peters. For many investors, that means implementing a tax-efficient strategy, which, among other things, limits the number of portfolio moves that trigger tax liabilities while using prior losses to offset realized gains.
Consider the following elements of a tax-efficient investment strategy:
THE IMPORTANCE OF ASSET LOCATION
Your first step toward a tax-efficient strategy is deciding where to hold your various investments—your asset location. Different investments and accounts have different tax treatments, and tax efficiency starts with holding investments in the appropriate account. "Everyone tends to skip over the asset location analysis," says Peters. "It’s not a hard process, and investors could really help themselves by taking the extra step."
For instance, investments with high interest income, high dividends, or high turnover, such as REITs, taxable bond funds, and high yield dividend stocks, may be most appropriate for a tax-deferred investment account. The reason: Interest and dividend payments, as well as the frequent selling that takes place with high turnover, can all have tax implications. Meanwhile, a taxable account may be best for individual securities held for a much longer time period; tax-advantaged securities, such as municipal bond funds; or mutual funds that take a low-turnover, growth-oriented investment approach.
The Cost of 2%1
A lack of tax efficiency in your investment strategy can lead to real costs down the road.
Let’s consider the following illustration: a hypothetical investor with a taxable portfolio that starts with a balance of $100,000 and is invested for 30 years. Each year, the portfolio loses two percentage points of return to taxes. While the portfolio grows to more than $400,000, it could have grown even further—to more than $750,000—without the impact of taxes.
Assumes a 7% average annual rate of return, a 2% drag from taxes, and no new contributions.
1Lipper Research Study, 2011. "Taxes in the Mutual Fund Industry: Assessing the impact of taxes on shareholders’ returns."
A long-term approach
Some investment strategies are inherently tax-efficient because they limit turnover of the securities within your portfolio. For instance, buy-and-hold investing can be tax-efficient since it involves holding individual investments over long periods of time—years or even decades. This approach can mitigate many of the tax liabilities that result from more frequent trading. Investing systematically and avoiding attempts to time the market—a daunting challenge even for the most experienced investors—can also help cut down on inappropriate selling.
In light of these principles, the ability to select investments that have long-term performance potential is critical. Peters takes this approach with the T. Rowe Price Tax-Efficient Equity Fund. "If we select stocks properly, we will own our shares a lot longer than managers who trade for short-term performance," says Peters. "Theoretically, we could take advantage of short-term opportunities if there was such a huge disparity that you could make that short-term trade and still be better off after taxes. But the markets are rarely that inefficient."