As the 2012 U.S. presidential election begins to take center stage with the mainstream media, individual investors are beginning to hear once again about the likelihood of changes to the U.S. tax code.
The 2010 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act extended the Bush-era tax cuts until the end of 2012. Unless further legislation is enacted, these expiring tax laws (accompanied by the introduction of new taxes resulting from the health care legislation and the limitations on itemized deductions) could result in a significant rise in tax rates (See Table 1).
But the situation could also provide investors and their advocates increased planning opportunities.
We estimate, using conservative assumptions, that taxable mutual fund investors surrendered as much as $18.6 billion of their hard-won mutual fund earnings for 2011 in taxes to Uncle Sam for doing nothing more than buying and holding their funds. Over the years, Lipper has produced research showing the benefits of keeping an eye on the drags on mutual fund performance that reduce investors' wealth, particularly loads, expenses and taxes.
We have shown that, despite significant tax-loss carryforwards being incurred by equity funds over the last several years, tax drag is in many cases at least as harmful to wealth creation as is expense drag; and often more harmful.
To illustrate the effect of taxes on mutual fund returns, consider that on average, over the last 10 years, equity and taxable fixed income funds have generated annualized load-adjusted pre-tax returns of 4.30% and 5.30%, respectively. However, on a pre-liquidation after-tax return basis, equity funds have given up on average of 0.73 percentage point of return to Uncle Sam each year, posting a 3.56% average annualized return. And over the same period, taxable fixed income funds—posting a 3.45% average annualized 10-year pre-liquidation after-tax return—have given up a whopping 1.85 percentage points of their return to taxes.
Given the return figures above, we can easily see the long-term benefit of accumulating wealth in a tax-advantaged account.
Let's assume that for the year 2011, a 10-year load adjusted return of 5.30% and the pre-liquidation after-tax return of 3.45% for the average fixed income fund are fair proxies for our 30-year $10,000 initial investment in the hypothetical compounding example in Figure 1 (on page 34). In that example we see that the tax-advantaged account is able to compound returns more effectively than is the taxable account. An average 1.86 percentage point tax drag over 30 years causes a decline in our after-tax return of $19,449 (almost two times our initial investment), compared to our tax-deferred return of $47,085.
With investors' continued predilection to put money into taxable fixed income funds and alternative asset funds (both generally considered tax-inefficient vehicles), asset location and tax-efficiency strategies are becoming more important.
Because of market volatility and the wish of many baby boomers to retire, investors and their advisors have begun diversifying portfolios against large equity market movements by looking for asset classes that have low or negative correlation with the traditional investments in diversified portfolios. As a result, investors are allocating larger portions of their portfolios to fixed income funds and alternative asset funds such as equity market-neutral funds, absolute return funds, extended large-cap funds, flexible portfolio funds, real estate funds, precious metal funds, and long/short equity funds.
However, caveat emptor.
Alternative asset funds have been experiencing greater tax drag than have traditional equity mutual funds.
The average alternative asset fund handed back on average 120 basis points of its return each year on a pre-liquidation basis to the government over the last 10 years, returning 5.12% versus the pre-tax load-adjusted return of 6.32%.
And the range of tax drag among Lipper's individual alternative asset fund classifications is quite broad (see Table 2). Currently, there are no alternative asset fund types that have a tax-managed structure that will help the taxable investor mitigate the amount the federal government takes.
To maximize after-tax portfolio wealth, investors and their advocates are encourage to use asset location tactics when they are immunizing their portfolios, that is, to place investments in tax-inefficient strategies in qualified plans or to search out tax-efficient vehicles such as municipal debt funds, insurance contracts, variable annuity products, or master limited partnerships.
With the Bush-era tax cuts expected to sunset this year and the newly enacted surtaxes beginning, the tax drag will become increasingly more important to the planning process for high-net-worth investors.
An asset location strategy takes into account the benefits of considering into which account types to put assets (taxable or tax-advantaged [IRAs, 401(k)s, 529 savings plans, or even variable insurance products]) in order to diversify portfolios.
The goal is to allocate one's assets among taxable and tax-advantaged accounts to defer taxes and to gain the best after-tax wealth for the portfolio. That is, highly tax-inefficient funds and investments such as high-paying income funds, whose distributions are generally taxed at the investor's highest marginal tax rate, should be placed in a tax-advantaged accounts, while equity funds and stocks that have low capital gains and income distributions should be moved to taxable accounts.
With proper planning, mid- to high-net-worth investors can boost their after-tax portfolio wealth with asset location strategies. One set of researchers concluded that investors using their proposed location approach could boost portfolio returns by 20 basis points per year on average over using identical allocations in taxable and tax-deferred accounts.
As we have shown in other papers, tax-conscious investors can use tax-managed funds, exchange-traded funds, index funds, and tax-exempt funds to help minimize tax drag in their taxable accounts. We have found that over the long haul paying attention to taxes can make a great difference to one's overall wealth creation.
But, asset location needs to be more adequately addressed. If investors have the right mix of asset classes that maximizes upside potential in their portfolio while at the same time lowering risk, then they can turn their attention to asset placement, that is, the strategic use of taxable versus tax-advantaged accounts to maximize overall portfolio wealth. Even if the Bush-era tax rates remain in place, a tax-conscious investment strategy will help with overall portfolio wealth creation.
With the proper asset location strategies, investors can aim for entertainer Arthur Godfrey's goal: "I am proud to be paying taxes in the United States. The only thing is—I could be just as proud for half the money."
Tom Roseen, is a senior analyst with Lipper. He is the editor
and an author of Lipper's U.S. Research Studies,
Fundflows Insight Reports and Fund Industry Insight Reports.