At Flat Fee Portfolios we believe in minimizing the impact of taxes. Most investors, and a surprising number of financial professionals, focus on the pre-tax return a portfolio generates while ignoring the real drag taxes can place on net portfolio performance.
Some of the most common investment mistakes include overlooking asset location, generating too much trading activity, and disregarding tax efficiency while selecting the investments within a portfolio.
Ignoring Asset Location
While much has been written about asset allocation, comparatively little has been written about asset location. We often see investors who have the same asset allocation across all account types, for example, IRA vs. non-qualified assets, but this can be a costly mistake. If you have two accounts, each with a different tax-treatment, it likely does not make sense to hold the same investments in both accounts. By considering how the location of the assets affects after-tax returns, you may be able to enhance portfolio performance without changing the overall investment mix.
Too Much Trading Activity
Most investors are too active and they pay a price in the form of increased transaction costs. Excessive trading in non-qualified accounts will likely result in an increase in short term trading gains and a higher tax bill. Investors would be better served by trying to limit their trading activity and increase the holding period so that it qualifies for long-term capital gains treatment.
Tax-Efficient Investment Selection
While many investors focus on pre-tax returns when evaluating potential investments, few think about the after-tax returns. Mutual fund managers may assume the money they are managing is either institutional or qualified retirement funds and thus ignore the tax implications of their investment decisions. This can be a costly mistake as mutual funds are required to distribute the capital gains generated as a result of their investment activity. With short-term capital gains rates as high as 39.6% and long-term capital gains rates as high as 23.8%, investors could lose a considerable portion of their return to taxes on gains that are distributed. Taxable investors would be better served by holding tax-efficient passive investments in non-qualified accounts and by keeping the actively managed investments in qualified accounts.