Mark Twain and Building Tax Efficient Portfolios

“What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” – Mark Twain

​The old adage, “It’s not what you make, but what you keep that matters,” is very real. As we have all heard, the only two things are certain in this world are death and taxes. Uncle Sam always gets paid. So, any way that you can legally pay less in taxes is an instant boost to your income and/or net-worth.

What are some ways to optimize your After-Tax Returns?

Optimize Use of Tax-Advantaged Accounts
Taxes are a major drag on returns, it’s always important to consider the account in which securities are held so as to minimize current and future tax impacts. Account selection is just one of many tax-related factors that must be considered early in an individual’s financial journey. 

Taxable Accounts provide greater liquidity and withdrawal flexibility, but don’t carry any tax advantages. Dividends, interest, or capital gains resulting from an asset sale get taxed each time one occurs. Taxable accounts, such as brokerage accounts, are best suited for tax efficient investments, such as passively managed funds, zero-coupon bonds, or no-dividend stocks. However, there is one way to effect your tax rate, by holding investments for longer than 1-year. If you hold an asset longer than a year before selling, you are then taxed at the current Long-Term Capital Gains Rate which is currently capped at 20% which is much lower than the Ordinary Income Tax Rate of 37%. So, if you need to sell, all else being equal, selling long-term assets is most tax advantaged    

Tax-Deferred Accounts are funded with pre-tax dollars. Though any activity in the account — dividends, interest, capital gains — is exempt from taxes, each distribution is subject to taxation. But, contributions to tax-deferred accounts can be deducted from tax returns, thereby lowering the amount of annual taxable income. This makes tax-deferred accounts like a traditional 401(k) or IRA best for both high-income earners and tax inefficient investments. Another advantage of having assets in these accounts are that you can rebalance your portfolio as much as you’d like without triggering any taxable events.  

​Tax-Free Accounts offer a benefit exactly as the name suggests: they are tax-free. Not only is activity within the account tax-exempt, but distributions occur sans tax as well. Because tax-free accounts like a Roth 401(k) and IRA are subject to income limits, it’s best to contribute as much as possible during periods of lower income, as well as store investments that can return the greatest amount. A Roth 401, Roth IRA, and 529 plans can be a very powerful tool for investors with extremely long-time horizons. See another article I wrote here about tax-free gains by turning $10k into $1 million using a Roth account.  
While is extremely difficult to avoid taxes entirely, optimizing the use of the different accounts based on your unique situation can dramatically impact how much money you actually end up with.

Use Financial Metric Tools to Analyze After-Tax Returns
In addition to a sale event (taxable account) or account withdrawal (tax-deferred account), investors can face additional tax liabilities due to mutual fund or ETF managers’ decision-making. Some useful metrics for evaluating funds potential tax liabilities include:

1. Tax Cost Ratio – the amount that a fund’s annualized return is reduced by taxes that investors pay on distributions. This includes stock and bond dividends as well as capital gains distributions. All else being equal, lower is better. Also known as tax efficiency, is important for investors to look at because it gives a clearer idea of how much the annualized returns will be reduced by taxation. For example, if a fund has a Tax Cost Ratio of (3Y) of 0.8%, it means on average investors lost 0.8% of their assets in taxes each year over the past 3 years.
2. ​​Tax Adjusted Returns – estimates the return an investor may realize after the tax impact of distributions but before selling a mutual fund, ETF, or closed-end fund. These figures use Morningstar’s tax cost ratio and assume the highest income tax bracket, which in turn give a more conservative estimate of tax adjusted returns. All else being equal, higher is better. Formula = ((1 - Tax Cost for the period) x (1 + Total NAV Return (monthly) for the period) - 1) x 100.
3. Turnover Ratio/Rate – the rate at which a fund changes out its holdings. A lower turnover ratio indicates fewer holdings changes and a lower risk of distributions and “churning” (transactions for the sake of trading commissions). The Turnover Ratio is usually between 0% and 100%. All else being equal, lower is better. Formula = Lessor of the purchase or sales value over the past year / Average portfolio value 
4. Potential Capital Gains – an estimated percentage of a fund’s assets that may be distributed as future capital gains. If a fund holds a lot of undistributed gains, investors may be hit with a tax liability for capital gains that occur before they buy into the fund.
5. Dividend Yield – The dividend yield is the sum of a fund or company's annual dividends per share, divided by the current price per share. Dividends can be taxed at more favorable rates depending on the length the security has been held. Formula = Annualized Dividends Per Share / Stock Price
6. Distribution Yield – The distribution yield applies only to mutual funds and ETFs. It is the ratio of all the distributions a fund paid in the past 12 months divided by the current share price of the fund. There is a major difference between the distribution yield and the dividend yield. The dividend yield will show you the percentage of the share price an investor received as dividends. The distribution yield, on the other hand, includes two components: dividends and capital gains. Understanding how these distributions will be taxed is important for tax planning purposes. Formula = All distributions of the fund in the trailing twelve months / price.

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The Bottom Line
Taxes are rarely clear-cut; as income levels, portfolio values, investment goals, risk tolerances, and life itself change over time—and each factor plays into tax considerations.
 
Having said that, it is possible to plan with various “what-if scenarios” to help maximize returns under various assumptions to limit tax liabilities owed to Uncle Sam. Using these best practices for tax-efficiency with a little up-front planning can lay a roadmap for success and maximize the rewards of a well-built financial plan.
 

​-Paul R. Rossi, CFA