Minimize Your Investment Taxes

Our Chief Investment Officer, Burt Malkiel, famed author of “A Random Walk Down Wall Street,” has spent the past 40 years explaining that investors can’t control the market, so they should focus their efforts on the three investment tactics within their control:

  • Diversify and rebalance your portfolio
  • Minimize fees
  • Minimize taxes

Previously, we published posts on the value of diversification and minimizing fees. However, too often the industry avoids talking about one of the most important aspects of maximizing your long-term investment results: minimizing taxes.

The Seven Ways to Minimize Taxes

There are seven ways Wealthfront can significantly reduce your investment taxes:

  1. Using Index Funds
  2. Rebalancing your portfolio with dividends
  3. Applying different asset allocations for taxable & retirement accounts
  4. Tax–loss harvesting
  5. Direct Indexing
  6. Minimizing taxes when transferring brokerage accounts
  7. Minimizing taxes when withdrawing money from your account

Each of these tactics can significantly improve your long-term, after-tax returns. To our knowledge no other automated investment service offers more than four of these capabilities and traditional advisors are not able to squeeze out as much benefit because they attempt to perform each service manually.

Index Funds

According to the Investment Company Institute, the mutual fund industry trade association, the average annual turnover rate experienced by equity fund investors between 1980 and 2013 was 61%. Turnover means transactions, and transactions are taxable events. Unlike actively managed equity mutual funds, index funds only turn over their portfolios when the companies that comprise their indexes change. In the case of the S&P 500®, on average only 4% of the companies that comprise the list of 500 companies changes each year. Very low turnover translates to almost no capital gains.

With this information as background we can do an analysis of the difference in annual taxes that result from each:

TaxTable_v3

If you assume the annual return for both an actively managed mutual fund and an index fund is 6% (this is a stretch since repeated research has shown that index funds outperform the average actively managed mutual fund by almost 2% per year) and they each earn 75% of their returns from appreciation (vs. 25% from dividends), then they each earn 4.5% pre tax from appreciation.  We then multiply the appreciation by the turnover to get the taxable gain for the year.

The taxes due on dividends from each are the same because the dividends received from each are the same due to the assumption that the returns and percentage of returns attributable to dividends are the same.

Assuming all the gains on the mutual fund are short term because of the high turnover (this is a little unfair since some will be long term, but it simplifies the analysis) and all the gains for the index fund are long term (this is accurate) then index funds would increase your annual after tax return by 1.13%! This assumes you apply a 42.7% marginal federal plus state short-term capital gains tax rate to the mutual fund turnover and a 24.7% marginal federal plus state long-term capital gains tax rate to the index fund turnover. We base this assumption on what an average Wealthfront client couple who earn $255,000 per year would have to pay if they live in California.

Rebalance Your Portfolio With Dividends

Rebalancing is the process of selling your investments that have performed well relative to your other investments and buying more of the ones that performed poorly.  This is the opposite of what most people feel comfortable doing. However, being contrarian is a common trait of most successful investors.  Rebalancing is an easy way to force yourself to be contrarian.

There are two approaches to rebalancing: time based and threshold based.  Most people (and financial advisors) employ time based (i.e. rebalance every quarter or year).  Vanguard’s research has shown that threshold-based rebalancing is superior to time-based rebalancing over the long term. Threshold-based rebalancing requires you to buy or sell an asset class if it strays from its original portfolio allocation by a certain percentage, say 5%. In other words if your allocation to US stocks is initially 30% and through superior performance it grows to 36% then you should sell stock to get back to your original allocation of 30%.

It is our experience that the only way to benefit from all seven tax minimization methods proposed in this post to their fullest extent is to implement these services in software.

A more tax-efficient way to rebalance is to use dividends generated from your investments (ideally index funds/ETFs) to buy more of your investments that performed poorly on a relative basis.  By doing so you will seldom have to sell the investments that have performed well relative to your other investments to keep your asset allocation within the acceptable thresholds. Fewer sales means lower taxes owed.

Unfortunately most people reinvest their dividends in the security that generated them rather than in their underperforming securities to avoid commissions (many dividend reinvestment plans will allow you to buy more stock for no commission). Buying more of a security that has outperformed only exacerbates the need to rebalance.

Our research has shown that using dividends to rebalance saves you 0.11% per year in taxes.

Different Asset Allocations for Taxable and Retirement Accounts

Employing expected after-tax returns rather than pre-tax returns for each asset class in your mean variance optimization model (the preferred approach to asset allocation employed by Wealthfront and most sophisticated institutions) results in different investment mixes for your taxable and retirement accounts that maximize your overall after-tax return.  For example dividends from Real Estate Investment Trusts (REITs) are taxed at ordinary income rates (for our typical client that means a marginal federal plus state tax rate of 42.7%) whereas dividends from corporate stocks are taxed at a marginal federal plus state tax rate of 24.7%.  Therefore on an after-tax basis it makes more sense to place your REITs in a retirement account than in a taxable account.

As we explained in Differentiated Asset Location For Young Investors, optimally allocating your investments based on their tax efficiency can add 0.10% to 0.50% to your annual return.

Tax-Loss Harvesting

Selling an investment that is trading at a significant loss and replacing it with a highly correlated but not identical investment allows you to maintain the risk and return characteristics of your portfolio and generate losses that can be used to reduce your current taxes.  Sure tax-loss harvesting only defers your taxes, but the tax savings generated from tax loss harvesting can be reinvested and compounded over time. As a result, you are almost always better off paying taxes later rather than sooner. In addition, the ultimate tax rate you pay on your decreased basis (long-term capital gain) will be lower than the tax rate from which you benefited when you harvested your loss (short-term capital loss).

Continuously looking for losses that can be harvested offers significantly more after tax benefit than harvesting once a year, which is typically done at year-end. Unfortunately the complexity of managing all your investment lots that result from deposits, withdrawals and dividend reinvestments make it almost impossible to do tax-loss harvesting more frequently than once a year unless you’ve built a software system to manage it for you. According to our research over the past 10 years, year-end tax loss harvesting would have added 0.6% to your annual after tax return.  Daily tax-loss harvesting (at the ETF level) could more than double that annual after-tax benefit to 1.5%.

Direct Indexing

Imagine the extra benefit you could generate if you could tax-loss harvest within an index. Direct Indexing conveniently and affordably enables you to directly own all the stocks in a major index (the S&P 500), and harvest losses they might generate. In other words, the overall index might be up, but you could harvest losses whenever an index component stock missed earnings and traded down. These tax savings could be reinvested and compounded over time into significant value. Direct indexing offers value to investors that index funds and ETFs cannot structurally provide because funds are prohibited from distributing tax losses to their shareholders. Depending on your portfolio size ($100,000 to $1 million), Direct Indexing could add an additional 0.20% to 0.50% to your annual after tax return over and above the benefit you could receive from daily tax-loss harvesting at the asset class (ETF) level.

Minimizing Taxes Upon Transfer

Many investors are reluctant to migrate the management of their portfolio to a low-cost automated investment service because of the taxes they’ll have to pay when they liquidate their current portfolio. Wealthfront has recently addressed this problem by automating a number of actions that minimize the taxes you might incur when you transfer an old portfolio to us:

  • Incorporate Your Existing Investments. If you transfer ETFs or stocks that match the securities utilized in our basic investment service or a Direct Indexing portfolio then we will automatically incorporate them into your portfolio, up to the appropriate amount for your recommended allocation, thereby reducing the number of securities that must be sold and capital gain tax you might incur.
  • Wait Until Your Capital Gains Become Long-Term. We hold your transferred securities until they qualify for long-term capital gains treatment. Our software monitors your account every day and sells securities only once they reach the one-year threshold required to qualify for the much lower long-term capital gains tax rate. By doing so the average Wealthfront daily tax-loss harvesting client can lower her marginal tax rate on the realized gain from a combined marginal state and federal short-term tax rate of 42.7% to a combined marginal state and federal long-term tax rate of 24.7%. These savings can be quite substantial.
  • Constant Monitoring To Minimize Realized Taxes. Our software evaluates changes to your transferred securities daily to look for opportunities to accelerate the migration of your assets to your diversified Wealthfront portfolio every day. For example, if one of your transferred stocks flips from having a short-term gain to a short-term loss, Wealthfront will take advantage of that movement to sell that stock and intelligently apply the proceeds to your low-cost, diversified portfolio.
  • Accelerated Migration through Tax-Loss Harvesting and Direct Indexing. Short-term capital losses from Wealthfront’s daily tax-loss harvesting and Direct Indexing services are automatically used to accelerate the sale of transferred securities that might have an offsetting short-term capital gain.
  • Limit Your Annual Tax Bill. In addition to all the aforementioned sale techniques that automate tax-minimization, Wealthfront’s new tax-minimized brokerage account transfer service allows you to specify the maximum capital gain taxes  you are willing to recognize in a given year, which gives you the ability to spread out your taxes over multiple years if desired.

Every individual brokerage account will vary, but we estimate that by intelligently automating the liquidation and reinvestment of existing stocks and ETFs, clients will realize significant benefits. To quantify the benefit from minimizing taxes upon account transfer, we analyzed every account transfer our clients used to fund their taxable accounts since we launched our automated investment service three years ago. Applying our new tax-minimized transfer capabilities could have saved our average client approximately 2.0% of her average account value.

Minimizing Taxes Upon Withdrawal

Investments typically must be sold to satisfy an account withdrawal request. If those investments are sold at a gain then they will typically generate a tax liability. However, when you withdraw money from a Wealthfront account, we minimize your tax liability by selling lots with losses first (since they generate no tax liability) followed by lots with only a small tax liability (typically those taxed at the lower long-term capital gains rate) and only then followed by lots with significant tax liability. As a result, you’ll likely only generate an insignificant tax liability when withdrawing a small amount of money.

Taxes Matter

The sum of the incremental after-tax benefits from pursuing the seven tax minimization strategies is 3% to 5% per year. For a $100,000 portfolio, that could represent an incremental $200,000 to $400,000 over 20 years over what you would have earned if you hadn’t paid attention to the seven tax strategies proposed in this post.

Can I Do These Myself?

It is possible for an individual to implement at least a portion of the seven methods required to minimize her investment taxes, but it is likely to take a lot of time. High-quality financial advisors can do everything except daily tax-loss harvesting, but they usually charge a base fee of at least 1% per year and often charge incremental fees for services like Direct Indexing. It is our experience that the only way to benefit from all seven tax minimization methods proposed in this post to their fullest extent is to implement these services in software.

Wealthfront is the only  automated investment service to offer all seven of these strategies and we deliver them for a flat 0.25% annual fee.

Diversify your portfolio. Seek to lower fees where possible. But don’t forget to minimize your taxes.

 


Disclosure

The information contained in the article is provided for general informational purposes, and should not be construed as investment advice. This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. The tax outcomes described are based on the profile of a typical Wealthfront client, and may not address your particular tax situation. Prospective investors are encouraged confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

The S&P 500 (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Wealthfront. Copyright © 2015 by S&P Dow Jones Indices LLC, a subsidiary of the McGraw-Hill Companies, Inc., and/or its affiliates. An rights reserved. Redistribution, reproduction and/or photocopying in whole or in part are prohibited Index Data Services Attachment without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

 

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