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’ve published strong opinions on the value of diversification and advisor 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 Four Ways to Minimize Taxes
There are four ways that financial advisors can significantly reduce your investment taxes:
- Index Funds
- Intelligently rebalance your portfolio with dividends
- Different asset allocations for taxable & retirement accounts
- Harvest losses where possible
Each of these can significantly improve your long-term, after-tax returns.
Unlike actively managed mutual funds, index funds have very little turnover, which means you incur almost no capital gains. According to the Investment Company Institute, the mutual fund industry trade association, the average actively managed mutual fund turns over 70% of its portfolio each year. Turnover means transactions, and transactions are taxable events.
In contrast, 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. With this information as background we can do an analysis of the difference in annual taxes that result from each:
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) and you apply the maximum federal tax rate to each then you see that mutual funds would lower your annual after tax return by 1.33%!
Rebalance Your Portfolio Through 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%.
A more tax-efficient way of doing this is to rebalance through the use of 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 the underperforming security 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.
In his book “Unconventional Success,” David Swensen, the Chief Investment Officer at the Yale Endowment, performed an analysis that showed optimal rebalancing could add 0.4% to your annual return. Our research has shown that using dividends to rebalance saves you 0.11% per year in taxes.
Different Asset Allocations for Taxable & Retirement Accounts
By paying attention to the expected after-tax return of each of your investments rather than pre-tax return, you can create 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 (maximum marginal rate of 39.6% plus the 3.8% surcharge for individuals who earn more than $200,000 for a total of 43.4%) whereas dividends from corporate stocks are taxed at 20% (with a 3.8% surcharge for individuals who earn more than $200,000 for a total of 23.8%). 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.
Harvest Losses Whenever Possible
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.
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 0.7% to your annual after tax return. Daily tax loss harvesting would have doubled that benefit to an additional 1.4% after tax.
The sum of the maximum incremental after tax benefit of pursuing the four tax minimization strategies is 2.94% to 3.34% per year. That represents an incremental $233,000 to $275,000 over what you would have earned if you invested a $100,000 account over 20 years compounded at 6% without paying attention to taxes.
Can I Do These Myself?
It is possible for an individual to implement at least a portion of the four methods required to minimize her taxes, but it is likely to take a lot of time. High-quality financial advisors can do everything except daily tax-loss harvesting, but usually for a fee that exceeds 1% per year. It is our experience that the only way to benefit from all four tax minimization methods to their fullest extent is to implement these services in software.
Wealthfront is the only software-based financial advisor to offer all four of these strategies and deliver them to clients for a flat 0.25% annual fee.
Diversify your portfolio. Seek to lower fees where possible. But don’t forget to minimize your taxes.
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. Prospective investors should 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. 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.