After recently filing their 2013 tax returns, many Americans are just now realizing how much more they paid in taxes compared to years past. And for many, the biggest tax increase was on their investment income.
As a result of the recent tax changes under the American Taxpayer Relief Act (ATRA), the Tax Policy Center, on its website, predicted that 77 percent of Americans paid higher taxes in 2013 than 2012. ATRA increased the top tax rate to 39.6 percent, increased payroll taxes and phased out personal exemptions and itemized deductions for certain taxpayers. The new tax act also increased the top rates for long-term capital gains and qualified dividends.
In addition, 2013 was the first year certain investment income became subject to the 3.8 percent Medicare surtax. With the additional surtax, the top tax rate for long-term capital gains and qualified dividends increased to 23.8 percent in 2013, a 59 percent tax hike. The top tax rate for short-term capital gains, interest and ordinary dividends rose to 43.4 percent.
Trouble for portfolios?
Capital gains, dividends and interest can erode a portfolio’s future returns on an annual basis. Unfortunately, most people don’t think about how taxes could affect their long-term investment goals.
Morningstar measures the tax cost ratio of most mutual funds, and while some funds will have a low tax cost ratio, other funds can have ratios as high as 5 percent or more each year. This means that a mutual fund with a 3 percent tax ratio will surrender 3 percent of its returns to taxes each year. The tax drag will be greater for those funds that are actively managed and have a high turnover ratio.
The turnover ratio of a mutual fund is measured as a percentage of the fund’s holdings that have been sold and replaced during the prior year. For example, if a mutual fund invests in 100 stocks and 50 of them are replaced, the fund would have a turnover ratio of 50 percent. The average actively managed fund has a turnover ratio approaching 100 percent. Because the fund’s holding period was less than one year, this could result in a lot of short-term capital gains being distributed to the investor each year. This is true even if the fund loses value. In the current tax environment, that means those short-term capital gains can be taxed at a rate as high as 43.4 percent. In addition, periodic rebalancing of a taxable portfolio to maintain proper asset allocation will cause further drag on investment returns.
How do I control investment-related taxes?
Of course, you can’t eliminate all investment-related taxes, but you can control them and improve a portfolio’s efficiency. If the investments are for retirement, does it make sense to pay taxes now on income that will be used in the future?
Certainly, if a retiree expects to be in a lower-income tax bracket in retirement, it may be better to defer taxes until that time. The fundamental value of tax deferral is simple: the longer you defer the tax obligation and keep money invested, the better.
Is tax-deferred compounding the ‘ninth wonder’?
It is often quoted that when it comes to compound interest, “He who understands it, earns it. He who doesn't, pays it.” How about the power of compounding on a tax-deferred basis? Is that the ninth wonder? Investing $500,000 in a taxable account growing at an 8 percent hypothetical annual rate, with an assumed annual tax rate of 28 percent, will be worth $1,532,496 after 20 years. In a tax-deferred account, it would be worth $2,330,481 on a pre-tax basis and $1,817,946 on an after-tax basis. That is 18 percent more on an after-tax basis.
Another way of looking at the power of tax-deferred compounding is to consider how much longer it would take for a taxable account to double. A tax-deferred account growing at a 7.2 percent annual rate will double in 10 years. This is often referred to as the “Rule of 72.” It would take a taxable account, using an average tax rate of 25 percent, 14 years to double, or 40 perecent longer.
Tax-deferred investing can be accomplished by investing in IRAs or 401(k) plans. For aggressive savers and high-net worth investors who easily max out contributions into qualified retirement accounts, non-qualified tax-deferred annuities are another option.
Time to explore alternatives?
The recent tax increases for investment income may require a fresh look at more tax-efficient investment alternatives. Many investors recently spent countless hours and dollars finding ways to maximize their allowable income tax deductions and exclusions. Those will affect their income tax for that year only, whereas tax deferral could affect income taxes over many years.
Take a look at your recent tax return. If you see large numbers on lines 8a, 8b, 9a, 9b and 13 on IRS Form 1040, you may not be investing in the most tax-efficient manner. This could be a good opportunity to identify investments that could reposition into a tax-deferred product like a variable annuity.
After all, one of the main goals of retirement planning is to end up with as much after-tax money as possible.