As clients begin preparing their tax returns, their focus should be not only on 2003, but also on managing their tax liabilities for 2004 and beyond. A particular focus should be on structuring and managing a tax-efficient portfolio. After all, the most significant single expense for most investors is taxes. A November 2002 Lipper study found that mutual fund investors give up from 1.3% to 2.5% of their returns annually to income taxes. Yet much more attention is given to items over which investors have less control, like management fees and trading costs. To address tax efficiency as it pertains to the design and implementation of an investment strategy, let’s first explore how recent tax law changes affect certain investment vehicles.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rate on qualified dividends and the maximum long-term capital gains rate to 15% from 20% (5% for gains taxed in the lower tax brackets).
The Act states that dividends received after 2002 by individuals and trusts from U.S. and “qualified foreign” corporations are taxed at a maximum Federal income tax rate of 15%, the same maximum applied to long-term capital gains. To qualify for this lower rate, the investor must satisfy the holding period requirement. The investor must hold the dividend-paying stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date for a particular dividend payment. In the case of certain preferred stock, the holding period is increased to more than 90 days during the 180-day period, beginning 90 days before the ex-dividend date.
An investor’s goals and risk tolerance, not taxes, will continue to guide his overall asset allocation decisions. However, this reduction in the tax rate on qualified dividends and long-term capital gains can have a significant influence on where investors decide to hold certain assets among taxable and tax-favored accounts. Basing a decision solely on tax rates, one could argue that holding appreciating assets and dividend-paying securities in a taxable account while holding interest-paying securities in a tax-deferred account makes the most sense from a tax-efficiency perspective. From an after-tax return perspective, it generally holds true that taxable, high-yield bonds belong in a tax-deferred account, due to the fact that a significant portion of the return is interest, which is considered ordinary income for income tax purposes. On the other hand, a portfolio of growth stocks that are expected to appreciate over time should be held in a taxable account, where the appreciation will be taxed at 15% upon liquidation. If the portfolio of appreciating stocks were held in a tax-deferred account, that appreciation would eventually be taxed at ordinary income tax rates, which are up to 35% for federal tax purposes, upon distribution rather than at the lower long-term capital gains rate of 15%.
This new rule may catch many investors by surprise if they are not careful. For example, there are several situations in which the dividend will not be considered “qualified,” and therefore will be taxed at the higher ordinary income tax rates:
Investment Interest Expense. When an investor incurs interest expenses throughout the tax year, these expenses are generally deductible to the extent of the individual’s net investment income. In other words, investors can deduct their margin interest expenses up to the amount of interest and dividend income they have. However, qualified dividends as defined in the Act will generally not be considered “investment income” for this purpose.
The only way the dividends can be characterized as investment income would be to elect to have them taxed at the higher ordinary income tax rates so as to deduct the interest expense incurred. For this to make sense, the deductibility of the expense must be more valuable on an after-tax basis than having the dividend taxed at the lower 15% rate. Investors who are on margin and are incurring expenses need to re-evaluate their situation. Does it make sense to continue to pay the margin interest now that the tax benefits may be minimized or eliminated all together?
Margin Accounts. When an individual maintains a margin account, the broker is usually authorized to lend shares in the account to other investors. When the shares are lent, the investor will receive a payment equivalent to the dividend–a “payment in lieu” of the dividend. Those payments do not qualify for the lower tax rate.
Investors who have margin accounts but don’t usually trade on margin should instruct their broker to take the accounts off margin in order to avoid the potential increased tax liability. Alternatively, investors may wish to advise their brokers through written instructions that shares should not be lent over record dates for dividend payments.
This issue can also catch mutual fund investors by surprise. The problem for taxable investors is that some mutual funds engage in securities lending in order to squeeze a little more return out of the portfolio. If this is the case, the mutual fund itself will receive payments in lieu of dividends and will be taxed as ordinary income to the unsuspecting shareholder, since it passes through as such. This only matters if the mutual fund is held in a taxable account.
Hedging and Taxes
Given the harsh investing environment of the past few years, more investors have turned to hedging their positions to limit their potential for loss. This is especially true if they hold a concentrated stock position with low tax basis. The new tax law makes such hedging, which can come in a number of forms using various derivatives and trading strategies, more expensive for most dividend-paying stocks on a relative basis.
An individual taxpayer who enters into common hedging or monetization strategies, such as collars, prepaid variable forwards, and spreads, may lose the ability to claim the new 15% tax rate on dividends paid on the underlying stock being hedged. This is so because, for a dividend to be considered “qualified,” the investor must meet the holding period requirements described above. To be considered “good” holding period days, the stock must be substantially unhedged.
Let’s say an investor holds shares of ABC Company and purchases a put option to protect her downside. In that case, the dividends paid by ABC Company will be taxed at ordinary income tax rates instead of the lower 15% rate for qualified dividends. In order to have the dividends qualify for the lower tax rate, the investor will need to sell the put option and satisfy the holding period requirements. As with any investment, the taxation of dividends should not be the only factor in deciding if an investor should hedge her position or not. Rather, it should be one factor, along with the all-important assessment of the investor’s risk tolerance and goals.
Dealing with AMT
Things get a bit more complicated when a client finds himself subject to the Alternative Minimum Tax (AMT). The AMT has been receiving a lot of attention recently, and for good reason. Absent further tax law changes, it is expected that approximately one-third of all taxpayers will be subject to AMT by 2010. The problem with AMT isn’t just that you may have to pay more income tax than expected. It could potentially affect the most tax-efficient way to invest your money.
For instance, the Alternative Minimum Tax can have a surprising impact on municipal bonds. The tax advantages of municipal bonds are obvious; they are tax-free for Federal purposes and possibly state purposes as well. However, if an investor is subject to AMT, beware. Private activity bond interest is a preference item that can make it more likely that an investor will be subject to AMT. Generally, a private activity bond generates a higher yield than other municipals such as general obligation bonds. However, if an investor is subject to AMT, the bonds’ effective yield will be slashed due to the increase in tax liability. Therefore, as investors are evaluating their current tax situation and find themselves subject to or close to being subject to AMT, they need to review their municipal bond portfolio for potential AMT traps disguised as private activity bonds.
Another area of focus for the increasing number of AMT victims is cash management. This is an area most investors take for granted. For a taxable account, we typically choose a municipal money market fund for our sweep account and cash holdings and leave it at that.
However, if an investor suddenly finds herself subject to AMT, chances are that tax-exempt interest generated from her municipal money market fund is no longer fully exempt from taxes. Why? Unless specifically stated otherwise, most municipal money market funds invest in what is known as “AMT paper,” which essentially is a very short-term private activity bond. Managers of municipal money market funds gravitate toward this type of cash equivalent due to its higher yield in an attempt to squeeze out an extra basis point or two in what is a very anemic time for yields on cash.
Let’s consider two actual municipal money market funds listed on an institutional manager’s Web site. We’ll call one fund MuniciMoney and the other MunicInvest. As of January 28, 2004, the seven-day yield for MuniciMoney was 0.85%, while MunicInvest had a seven-day yield of 0.78%. The major difference between the two is that MuniciMoney had 43.5% of its portfolio allocated to AMT paper while MunicInvest had no AMT paper. By doing so, the manager of MuniciMoney was able to generate an additional seven basis points. However, if an investor is subject to AMT, that additional seven basis points will be wiped out due to the increased tax liability. In fact, based on the top AMT rate of 28%, the after-tax yield of MuniciMoney is 0.75%, or three basis points lower than MunicInvest.
Remember, to build and manage a tax-efficient portfolio, investors need to understand their entire tax profile. Taking simple steps throughout the year, like harvesting losses to offset realized gains or identifying specific lots to sell to minimize such gains, can go a long way in increasing tax-efficiency. Done correctly, those simple acts can significantly increase investors’ after-tax wealth over time.
William J. Cafero, CIMA, is a senior manager with Ernst & Young LLP’s Personal Financial Counseling practice in New York who specializes in planning services for high-net-worth individuals and corporate executives. He can be reached at email@example.com.