At Flat Fee Portfolios we believe that minimizing the impact of taxes matters. 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 a portfolio. Some of the most common investment mistakes are ignoring tax efficiency in selection of a portfolio’s investments, too much trading activity, and focusing on asset allocation and not asset location.
Tax-Efficient Investment Selection
While many investors focus on pre-tax returns when evaluating potential investments, few think about the after-tax returns. This can be a costly mistake as mutual funds are required to distribute the capital gains they internally generate as a result of their investment activity. Additionally, mutual fund managers often assume the money they are managing is either institutional or qualified retirement funds and thus ignore the tax implications of their investment decisions. With short-term capital gains rates as high as 35% and long-term capital gains rates currently at 15%, investors could lose a considerable portion of their return to taxes on gains that are distributed. Taxable investors would be better served by holding more tax-efficient passive investments, which are less likely to have capital gains to distribute, in their non-qualified accounts and keep the more actively managed investments in their qualified accounts.
Too Much Trading Activity
Most investors are too active. They pay a price for this in increased transaction costs, but in non-qualified accounts they also generate a higher tax bill. Assuming the trading generates only long term capital gains, an investor’s activity needs to generate a return that is 17.6% higher than simply holding a passive investment. If the gains are short-term, and consequently taxed as ordinary income, the activity may need to generate a return that is almost 54% higher than taking no action. Investors would be better served by trying to limit their trading activity so it is infrequent and, when trading does occur, it qualifies for long-term capital gain treatment.
Ignoring Asset Location
While much has been written about asset allocation, comparatively little has been written about asset location. Thinking about where an investor owns what they own matters when focusing on generating after-tax returns. A common mistake we see is to have one asset allocation that is the same regardless of account type. If you have two accounts, each with a different tax status, it does not necessarily make sense to own the same investments in both of them. Focusing on asset location could enhance overall return on the portfolio without even changing the overall investment mix.