Don’t Lose Investment Returns to Taxes

2013 Tax Rates

As part of The American Taxpayer Relief Act of 2012, several tax changes took effect January 1, 2013:

  • The Medicare tax rate on households with earned income of more than $250k increased from 1.45 percent to 2.35 percent. The same increase occurred for singles with earned income of more than $200k.A new Medicare tax was introduced for the same group earning more than investment income at a rate      of 3.8 percent. The surtax applies to taxable interest, dividends, capital gains, passive activity income, rents, royalties and annuities.
  • The top marginal income tax bracket moved to 39.6 percent, up from 35 percent.
  • The top long-term capital gains rate moved to 20 percent, up from 15 percent.
  • Qualifying dividends continue to have tax favored treatment.
  • The estate and gift tax exclusion amount is retained at $5 million indexed for inflation. The top tax rate increased to 40 percent, up from 35 percent.

Tax Damages Quantified

As taxes and exemptions seem to come and go like the seasons, individuals and their advisors need to be ever-mindful of their impact on hard-won investment gains.

Mutual fund investors paid approximately $736 million in 2009 due to short-term capital gains taxes, $149 million in long-term capital gains taxes and $12 billion because of taxes on dividends.1 That amounted to equity fund investors giving up an average of 98 basis points of return to taxes, in addition to 147 basis points in expenses.2 And while those numbers are disturbing, they came in a year when the tax burden was relatively light. Finally, consider that those taxes covered little more than holding the fund and reinvesting gains, essentially a buy-and-hold strategy.

Here’s another way to assess the damage of taxes. A hypothetical $100,000 portfolio invested in 60 percent stocks and 40 percent bonds in 1979 would have grown to $3.62 million before taxes by 2012. However, with no efforts to mitigate the tax effect, Uncle Sam would have eaten more than 49 percent of the gain, lowering the investor’s wealth to a little more than $1.8 million.3

What can you and your advisor do about it?

Here are a few of the strategies that can be utilized to minimize taxes on investment earnings:

  • Tax-lot accounting: A method of accounting for a portfolio in which the manager tracks the purchase and sale price and cost basis of each security. This allows the core manager to “swap” a batch of stocks with long-term gains for a batch with smaller, short-term gains.
  • Loss harvesting: Allows the core manager, holding a stock at a loss, to sell all or part of it to realize the loss and create an “asset” that can offset some future gain.
  • Wider rebalancing ranges: Helps the manager to offset the tax consequences of trades made to keep the investor’s portfolio within a range of the target allocation, say 60/40. A higher rebalancing range reduces the number of trades, thus lowering taxes.
  • Gain-loss offset: Involves selling securities at a loss that have dropped in price at year-end at a loss to offset gains made from securities that have increased in price. There are other tools that fall within the category of “tax-aware” trading: delaying the sale of stocks that are about to become a long-term holding; identifying the most tax-advantaged stock sales for the purpose of making charitable donations; and identifying the most tax-advantaged (high-cost basis) stocks for investors seeking regular income from their portfolios.

1Lipper, Taxes In the Mutual Fund Industry – 2010.

2Lipper, op.cit.

3 Parametric Portfolio Associates: 60 percent Russell 3000; 40 percent Barclays Capital Aggregate; no liquidation. Interest income and dividends are taxed annually at the historical top marginal tax rate; capital gains are realized at 50 percent per year and are taxed at the historical long-term capital gains tax rate.

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