Many Americans began the New Year relieved that the fiscal cliff had been averted, if only temporarily. But there is no escaping their biggest fear—that an increase in their federal tax bill is inevitable. Congress continues to hammer out the final details, but one thing is certain: anyone drawing a salary or receiving other income will be hit with more taxes. And the higher their income, the bigger the bite.
The situation becomes even more challenging because taxes are rising at a time of increasing volatility. Since the crash of 2008, wild swings in the market have become the norm, and show no signs of abating. As we’ve seen in recent months, uncertainty in Washington sends Wall Street into a tailspin weekly, if not daily.
In a study by Cogent Research, 70 percent of Registered Investment Advisors (RIAs) surveyed say ongoing volatility is a top concern for their clients1. For many, the solution is using more liquid alternatives and tactical management. In a survey conducted by Jefferson National, 68 percent of advisors indicated they have already increased their use of alternative investments, and most expect to continue increasing their allocation to alternatives over the next five years, as they anticipate ongoing volatility2.
While liquid alternatives and tactical management have proven effective for managing volatility and optimizing risk-adjusted performance, one of the biggest obstacles to using them is that they tend to be highly tax-inefficient. So it comes as no surprise then that a new survey of RIAs and fee-based advisors released by Jefferson National last month found that 85 percent say a low-cost tax-deferred investing solution would be beneficial to clients in a time of rising taxes—and in a time of ongoing volatility.
After-tax return—or what’s left in an investor’s pocket at the end of the day—is the true yardstick to measure performance. For many, optimizing after-tax returns begins by consulting with an advisor to discuss the concept of “asset location,” a strategy to determine which assets in the portfolio should be located in taxable vehicles and what portion should be tax-deferred.
In an environment where taxes are rising and every basis point of yield matters, it’s important to pay close attention to the tax-efficiency of investments. Certain asset classes and strategies are tax-inefficient because they generate short term capital gains or ordinary income, which are taxed at higher rates. These include any actively managed funds or strategies, as well as most liquid alternatives, taxable bond funds, commodities and many other non-correlated assets. Typically, it’s best to “locate” these tax-inefficient investments inside a tax-deferred vehicle3, provided you don’t run into high fees, low contribution limits or limited fund selection.
The first step in an asset location strategy is to maximize contributions to qualified plans such as an IRA or 401(k). Investors not only postpone paying taxes on the money they contribute, they also postpone paying taxes on investment gains to make the most of tax-deferred growth. It’s especially important to maximize 401(k) contributions when employer matching is available—in essence, that’s found money.
No-load VA is a one solution
For aggressive savers and high-net-worth investors who can easily max out the low contribution limits of qualified plans, a low-cost, no-load variable annuity (VA) is an important option—one that is often overlooked. But in recent years, a new breed of VAs have been designed exclusively for tax-deferred investing—with low fees, greater transparency and more fund choices, while stripping away commission and complex insurance components.
Research shows that small investors often look at the return on an investment, but overlook how taxes can erode those returns. Morningstar estimates that over the 74-year period ending in 2010, investors who did not manage investments in a tax-sensitive manner gave up between 100 and 200 basis points of their annual returns to taxes. This is another reason why tax deferral is so relevant today. A low cost tax-deferred investing solution can help investors manage the impact of taxes to increase returns—without increasing risk.