Many typical portfolios have more than 40 percent of their returns taxed away. Millions of investors are giving too much of their tax dollars back to Uncle Sam due to inefficient investing. Even though you cannot escape taxation altogether, you can cut this burden with a few simple strategies.
Tax-efficient investing does not apply to your individual retirement account and retirement money. It is most relevant if you are in a middle or upper tax bracket of at least 28 percent.
Most of the investment management industry has all but ignored the effects of taxes on your portfolio. Investment management has keyed on nontaxable accounts, such as pension accounts, ignoring individual investors' taxable portfolios.
The mutual fund industry has also continued, for the most part, to ignore taxes and pretend that every customer is in an IRA or 401(k) account. Generally, brokers tend to ignore taxes. The way brokers make money is in buying and selling stocks that trigger capital gains, or selling load funds, which trigger yearly gains.
Holding a good-quality common stock is one of the best tax shelters left. Only bank trust departments and money management firms that cater to the higher tax payers have historically stressed tax-efficient investing through individual stock and municipal-bond management.
Some breakthroughs have occurred with tax-efficient mutual funds, however. Morningstar, the leading independent reviewer of mutual funds, has started to compute a "tax efficiency ratio." This ratio represents the percentage of the fund's pretax return that an investor was able to keep after taxes.
Funds rate from 60 percent to 100 percent, which is a tremendous difference in after-tax returns. Index funds typically have low turnover and high "tax efficiency."
If you have less than $200,000 in your taxable portfolio, looking for tax-efficient equity funds, such as an index fund, and a municipal bond fund is a good strategy.
If you have built up a substantial taxable portfolio, it would pay to seek professional, tax-efficient investment management from your local bank trust department or money management firm. These firms will work with your CPA and estate attorney to maximize your after-tax return.
Unlike many no-load mutual funds, which distribute capital gains yearly, trust departments and money managers will manage individual stocks, creating taxable gains and income when it makes sense for you. They also have expertise in individual municipal bonds and buy them at low commissions. These managers get paid on a percentage of your assets after taxes, so they share in your interest to build the portfolio and to maximize your after-tax return.
Taxes are relevant and certain. Last year's hot mutual fund could be this year's dog. People should spend more time looking at tax effects they can control and less time on betting on the next hot investment. Making a portfolio more tax efficient is an easy way to immediately increase after-tax returns.