Maximizing your after tax investment income
Higher tax rates increase importance of choosing tax efficient investments
The major options available to an individual for equity investments are actively managed mutual funds, index mutual funds, exchange traded funds (ETFs), and direct investment in stocks. Under the American Tax Relief Act of 2012, upper income investors face significantly higher tax rates on equity capital gains and dividend income. Consequently, it is particularly important for this cohort of investors to give careful thought to the relative tax efficiency of these investment options, as discussed in this article. Of the four major options listed above, actively managed funds are the least likely to meet the conditions of tax efficiency. This is primarily because the fund manager often engages in high portfolio turnover. As a result, an actively managed fund often fails to obtain significant deferral of capital gains and may unnecessarily generate short-term capital gains (passed through as ordinary income) and nonqualified dividends.
INVESTMENT INCOME
HIGHER TAX RATES INCREASE IMPORTANCE OF CHOOSING TAX EFFICIENT INVESTMENTS
As a result of the American Tax Relief Act of 2012 (ATRA) and the Health Care and Reconciliation Act of 2010 (HCERA), the effective tax rate on dividends and capital gains from investments in equities has significantly increased for upper income taxpayers. Upper income taxpayers are now subject to a 20% rate on long-term capital gains and qualified dividends and an additional 3.8% tax on unearned income, including dividends and capital gains. Also, if a taxpayer’s adjusted gross income (AGI) is above a certain level, exemptions and itemized deductions begin to be phased out. Since capital gains and dividend income increase AGI, at certain levels of AGI, the effective tax rate on capital gain and dividend income is increased as income from these sources results in a loss of the itemized deduction and exemption amounts. Details of these tax law changes, resulting in a higher tax rate on capital gains and dividends, are explained below.
Higher maximum rates on capital gains and dividends
A capital gains rate of 20%, enacted as part of ATRA, applies to adjusted net capital gains (long-term capital gains less short-term capital losses) for individuals if the gain would otherwise be taxed at the 39.6% rate. Qualified dividends are taxed at the same rate as adjusted net capital gains. As a result, a 20% rate also applies to qualified dividends if the dividends would otherwise be taxed at a 39.6% rate. For 2014, the taxpayer is subject to the 39.6% rate if taxable income exceeds $457,600 for joint filers, $432,200 for heads of household, $406,750 for single filers, and $228,800 for married taxpayers filing separate returns.
3.8% Medicare tax
The 3.8% Medicare tax, enacted as part of HCERA, was effective beginning in 2013. It applies to the lesser of the taxpayer’s net investment income or the taxpayer’s modified adjusted gross income (MAGI) over a certain threshold amount. MAGI is adjusted gross income plus the net amount excluded as foreign earned income under Section 911(a)(1). The threshold amounts are $250,000 for joint filers, $200,000 for heads of households and single filers, and $125,000 for married taxpayers filing separate returns. These threshold amounts are not indexed for inflation. Net investment income generally includes interest, dividends, annuities, royalties, rents, and capital gains.
Example 1: Xavier, a single filer, has a MAGI of $220,000 and net investment income of $40,000 from stock dividends and the sale of equities. The 3.8% Medicare tax is applied to the lesser of $40,000 or $20,000 ($220,000 – $200,000). The Medicare tax will be $760 ($20,000 x 3.8%).
Phase-out of exemptions and itemized deductions
Under ATRA, personal and dependency exemptions and itemized deductions are again phased out once the taxpayer’s AGI exceeds certain thresholds levels. For 2014, these threshold levels are $305,050 for joint filers, $279,650 for head of households, $254,200 for single taxpayers, and $152,525 for married taxpayers filing separately. The allowable personal and dependency exemption amount is phased out at the rate of 2% for every $2,500 of income or fraction thereof above these threshold levels. The allowable exemption is completely eliminated when AGI is more than $122,500 above the exemption thresholds. Consequently, the allowable exemption deduction is completely eliminated when AGI is at a level above $427,550 for joint filers ($305,050 + $122,500) and $376,700 for single filers ($254,200 + $122,500). Over the range that the allowable exemption amount is phased out, for each exemption that is phased out, the effective tax rate increases by around 1%.
A 1% increase in the effective tax rate over the phase-out range for each exemption can be calculated as follows: Each exemption deduction that is completely phased-out results in an increase of $3,950 of taxable income (the exemption deduction for 2014). Assuming a marginal tax rate of 33%, the result would be a tax liability increase of $1,304 ($3,950 × 33%). Over the phase-out range of $122,500, this translates to an approximate 1% tax rate increase ($1,304/$122,500).
Itemized deductions are phased out at the rate of 3% of a taxpayer’s AGI above the applicable threshold. No more than 80% of the taxpayer’s itemized deductions, however, may be phased out. Moreover, certain itemized deductions—medical expenses, investment interest expense, casualty and theft losses, and gambling losses—are not subject to the 80% limit and are fully added back in determining the maximum overall limit. The itemized deduction phase-out generally translates to an approximate 1% increase in the effective tax rate, at a marginal tax rate of 33%. (3% increase in taxable income due to the 3% phase-out percentage × 33% marginal tax rate = 1%)
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Characteristics of a tax efficient vehicle
Because of these changes—higher maximum tax rates on capital gains and dividends, a 3.8% Medicare tax on net investment income, and the phase-out of exemptions and itemized deductions, the tax rate on capital gains and dividend income from equity investments is significantly increased for upper income taxpayers. Consequently, it is now particularly important that these investors weigh which investment vehicles will minimize the impact of taxes from dividends and capital gains. Most investors choose to delegate the management of their equity investments to an outside party, rather than directly investing in stocks. There are arguably three major vehicles that an investor may use when entrusting an outside party to manage stock investments: actively managed mutual funds, index mutual funds, and exchange traded funds (ETFs). As previously indicated, an investor may also opt to own stocks outright rather than using an outside party. The relative tax efficiencies of each vehicle will be examined in light of the characteristics that constitute an efficient equity investment vehicle. These characteristics are as follows:
- Few or no capital gains are passed through from these investment vehicles to the investor, particularly gains that might be attributed to a previous investor. Any gains that are passed through are classified as long-term capital gains.
- Capital losses are passed through to the investor.
- Dividends are classified as qualified rather than nonqualified.
How mutual funds and ETFs are taxed
Mutual funds and ETFs work by pooling proceeds from investors and investing those proceeds into stocks, bonds, and money market securities, in accordance with the fund’s investment objective. Actively managed funds, passive index funds, and ETFs are all taxed as regulated investment companies (RICs) under Section 852. Net long-term capital gains realized by a RIC are passed through as capital gain dividends and are taxed at long-term capital gain rates (Box 2a of IRS Form 1099-DIV). Net short-term capital gains realized by the RIC are passed through as ordinary dividends (Box 1a of IRS Form 1099-DIV) and are not included as qualified dividends (Box 1b of IRS Form 1099-DIV). Consequently, they are taxed at ordinary income tax rates.
All dividend income received by the RIC is passed through as ordinary dividend income (Box 1a of IRS Form 1099-DIV). If the dividend income meets the conditions of Section 1(h)(11), it is also classified as qualified. (Box 1b of IRS Form 1099-DIV). Net capital losses realized by a RIC are not passed through to the shareholders but may only offset capital gains realized by the RIC. Unused capital losses are carried forward indefinitely. For a RIC to pass through to the shareholders the right to take a foreign tax credit, more than 50% of its total assets at the end of the year must consist of foreign stock investments.
Why actively managed funds are usually not tax efficient
Of the four primary ways to own equities—actively managed funds, index funds, ETFs, and direct ownership—actively managed mutual funds are the least likely to meet the conditions of tax efficiency, as explained below. Arguably, this is due in part to the compensation structure of fund managers, which is normally based on before-tax returns rather than after-tax returns. Consequently, there are not incentives to manage the fund with regard to tax efficiency.
High portfolio turnover.
According to the ICI 2013 Investment Company Fact Book, 24 the stock turnover of equity funds averages 62% annually. This means that, on average, stocks are held by the fund for less than two years. This turnover percentage takes into account index funds, which usually have much slower turnover rates, often in the single digits. Many actively managed funds, of course, also have modest annual turnover. Information about a fund’s historical turnover rate may be obtained at Morningstar®.
Portfolio turnover primarily occurs because the fund manager believes that actively buying and selling stocks will result in market outperformance. Turnover may also occur because of involuntary events. For example, a fund may be forced to redeem shares as a result of the merger or acquisition of an existing holding. It may also be forced to redeem shares when it experiences net redemptions, that is, when share redemptions exceed share purchases. Net redemptions are most likely to occur when the fund experiences a period of poor performance, especially relative to funds with the same investment style, e.g., large cap growth funds.
Tax inefficiencies as a result of high portfolio turnover.
The high portfolio turnover of a fund may result in three tax inefficiencies: (1) frequent capital gain realization; (2) the realization of short-term capital gains; and (3) the distribution of nonqualified dividends.
Frequent capital gains realization provides the investor with little opportunity to defer paying capital gains tax on stocks that have appreciated in value. Deferring payment of capital gains results in higher after-tax returns.
Frequent capital gains realization also increases the likelihood that stocks will not be held for more than one year and will consequently be classified as short-term capital gains. Net short-term capital gain rates generated by a mutual fund are not only taxed at ordinary income tax rates, but they have an additional disadvantage compared with short-term capital gains generated at the individual investor level. An individual investor who generates short-term capital gains can use those gains to offset capital losses, which otherwise can be used to offset only up to $3,000 of ordinary income per year. Since short-term capital gains generated by a mutual fund are passed through to the shareholder as ordinary dividends, the investor loses the opportunity to use the short-term capital gains to offset capital losses.
At a company’s ex-dividend date, the price of a stock will normally decline by the amount of the dividend since the investor will no longer be eligible to receive the dividend. Therefore, buying right before the ex-dividend date and then selling the stock soon thereafter will often result in a short-term capital loss. An investor is effectively trading favorably taxed qualified dividend income in exchange for a short-term capital loss. To discourage this, the dividend will not be classified as qualified unless the taxpayer holds the dividend-paying stock for at least 61 days during a 121-day period, which begins 60 days before the ex-dividend date. A fund with a high turnover rate is more likely to not meet the required 61 day holding period for a portion of their dividends, with the result that these dividends will not be classified as qualified.
Other tax inefficiencies.
When a shareholder purchases a stock mutual fund, part of the purchase price includes the shareholder’s share of the fund’s realized stock appreciation or depreciation, as well as accrued dividends. Distributions of realized gains and dividends are made to shareholders according to their proportionate ownership in the fund, regardless of when the shares in the fund were acquired. For most mutual funds, distributions are made at the end of the year. Distributions are not prorated according to the length of time the mutual fund is held. A shareholder who acquires shares in the fund immediately before a distribution date receives the same distribution per share as another shareholder who has owned the fund the entire time since the prior distribution.
This distortion will be corrected should the fund be sold because taxable distributions increase the shareholder’s basis in the fund. The shareholder is not made whole, however, because, in the interim, he or she is making an interest-free prepayment of income taxes. Shareholders may, however, avoid paying taxes on realized gains and dividends that accrue by timing the purchase of mutual fund shares to occur soon after the distribution.
As discussed previously, for all RICs, including actively managed funds, net capital losses are not passed through to the shareholders but rather carried forward to be offset against capital gains in future years. The only option the investor has, in order to take immediate advantage of a fund’s net capital loss, is to sell the fund outright.
Index funds are usually more tax efficient than actively managed funds
Passively managed funds, or index funds, have as their exclusive goal to track a specific benchmark, such as the Standard & Poor’s 500 Index. They do not buy and sell funds with the goal of outperforming the market. Since they are not actively managed, they normally have a much lower stock portfolio turnover rate. For example, the low cost, well-regarded Vanguard Total Stock Market Index Fund has a very low average portfolio turnover of only 3.2% annually. This index fund seeks to mimic an index that tracks the performance of the entire U.S. stock market. An index fund, such as this one that tracks a broad market index, in which the composition of the index will change infrequently, needs to trade stocks only occasionally to match the index.
An index fund that tracks a narrower index is likely to require more stock turnover to match its benchmark index. For example, the Vanguard Small-Cap Index Fund averages an annual turnover of 13.9%. While this turnover rate is well below that of the vast majority of actively managed funds, it is considerably higher than that of the Vanguard Total Stock Market Index Fund. Because index funds generally experience considerably less portfolio turnover than actively managed funds, on balance they will throw off less capital gains, particularly short-term capital gains, as well as dividends that are not qualified. In a study conducted by Morningstar®, across all investment style groups, actively managed funds averaged significantly more capital gain distributions per year. For example, for the large blend equity category, over a five-year period, the active mutual funds averaged a capital gain distribution of 1.92% of net assets per year, whereas passively managed funds averaged a minuscule capital gain distribution of .16% of net assets per year.
Like an actively managed fund, however, an index fund may experience turnover as a result of net redemptions. A low cost index fund that is adept at matching its benchmark index, however, is less likely to experience net redemptions because it will probably not experience a period of underperformance relative to funds with the same investment style.
Index ETFs are generally slightly more efficient than index mutual funds
ETFs, like mutual funds, are legally structured as RICs. Unlike mutual funds, however, they are traded in the same manner as stocks. Like stocks, ETFs are priced continuously throughout the day on organized exchanges such as the New York Stock Exchange. Additionally, they may be sold short and purchased on margin.
In the past several years, many ETFs have been introduced with objectives other than tracking a broad market index such as ETFs that are actively managed. Other ETFs have been introduced that track a very narrow segment of the market such as a specific foreign country or a specific industry. Other ETFs invest in commodities or currencies, are set up as limited partnerships or grantor trusts, or are leveraged or short a particular market index. These ETFs often have a poor track record for tax efficiency and may not be suitable for conservative investors pursuing a long term buy-and-hold strategy. The following discussion of ETFs is limited to index ETFs that track a broad market index.
Legal structure of ETFs eliminate triggering capital gains due to redemptions.
Index ETFs are structured in such a way that, compared with index mutual funds, there is significantly less likelihood that redemptions from an ETF will trigger realized capital gains. This is because retail investors buy and sell shares of an ETF in the open market rather than directly from the ETF. Consequently, the ETF does not have to redeem shares that might trigger capital gains for the remaining shareholders. Instead, as explained below, creation units are used to redeem shares as well as issue additional shares.
To issue additional shares, the ETF manager sells creation units in large blocks to investment professionals (not retail investors), including institutional investors, exchange specialists, and broker-dealers, in exchange for a basket of securities that reflects the composition of the benchmark index. The market professional will either hold the creation units for his or her own portfolio or will divide up the creation units into smaller lots and sell these lots on the open market. Retail investors will purchase either these shares or shares sold by other retail investors in the open market.
To redeem shares, an in-kind basket of stocks that reflects the constitution of the tracked index is transferred from the ETF manager to the institutional investor. The stocks to be redeemed are typically those with the lowest basis, leaving the higher basis stocks with the ETF manager. Consequently, when ETFs need to sell shares of stock because of a change in the targeted index, smaller realized gains, if any, will be distributed to the retail investor. Upon receiving stocks from the ETF manager, the institutional investor, in turn, surrenders ETF shares to the ETF manager—shares already held by them or acquired by them in the open market.
Under Section 311(b), there is a taxable gain when the fair market value of distributed property exceeds the shareholder’s adjusted basis in that property. Fortunately, under Section 852(b)(6), RICs, including ETFs, are not subject to the aforementioned Section 311(b) taxable gain if they distribute shares of stock instead of cash.
The same Morningstar® study that compared the capital gain distribution record of actively managed funds with that of index funds also included the capital gain distribution track record of index ETFs that track a broad index. Over a five-year period, across all styles except emerging markets, there were no capital gain distributions. For the emerging markets style, the capital gain distribution averaged an insignificant .01% of net assets per year.
Investing directly in individual stocks provides the best opportunity for tax efficiency
The following considerations highlight how direct stock investments can provide for the greatest tax efficiency.
Harvesting capital losses.
Unlike an investor in a RIC, someone who invests directly in stocks has the opportunity to directly harvest capital losses. These capital losses may be used to offset, without limit, the investor’s capital gains from all sources and up to $3,000 of an individual’s noncapital gain income. While it is generally sound tax planning to defer the recognition of capital gains, capital losses should generally be recognized immediately as long as there is offsetting capital gains or ordinary income (up to $3,000).
Wash sale rules.
On occasion, an investor may believe that a stock price decline is temporary. Consequently, he or she may wish to sell a stock to recognize the loss but immediately thereafter reacquire it. If this is the case, the investor needs to be aware of the “wash sale” rule. Under the wash sale rule, if a substantially identical stock or other security is purchased within 30 days before or after the date of selling the original security for a loss, the loss is disallowed. The loss would be allowed, however, to be added to the cost of the reacquired securities. The wash sale rule may be avoided simply by waiting 31 days after an equity is sold before reacquiring it. This strategy would make the most sense if the security has a history of relative price stability. Another simple strategy is for the investor to purchase another stock in the same industry as the replacement stock, as price movements of stocks in the same industry are often highly correlated.
Specific identification method.
By directly investing in stocks, the investor has the opportunity to use the specific identification method when selling stocks. Under the specific identification method, if an investor has acquired multiple blocks of shares of the same stock on separate occasions and the holding is only partially liquidated, the investor may designate which blocks of shares are to be sold. While the specific identification method is also available to RICs, the direct investor has the advantage of being able to control which lots to sell in light of the investor’s other capital gains or losses for the year.
To minimize the gain, the investor should designate those lots with the highest basis. If a stock’s share price has been generally rising since the first block was acquired, the investor should designate the last blocks of shares acquired as the ones to be sold. The investor, however, should designate only those blocks that have been held for more than 12 months to avoid recognition of short-term capital gains. If the investor fails to designate which blocks of shares to sell, the investor must use the FIFO method.
Donating individual stocks to charity.
In general, an investor is allowed to deduct the fair market value of appreciated property to charity if selling the property would result in a long-term capital gain. This includes both stocks and RICs. To take maximum advantage of this tax provision, the investor should contribute securities that are highly appreciated relative to their bases. The advantage of contributing individual stocks, particularly those that have been held for a long time, is the greater ease in identifying ones that are highly appreciated. While RICs may hold stocks that are highly appreciated, they are likely to be mixed with stocks that are only moderately appreciated, or even depreciated, particularly if the RIC has a high turnover rate. Typically, the result is that the RIC is not highly appreciated relative to its basis.
Increased rate of return for stocks from loss harvesting and application of specific identification method.
Studies have demonstrated that the after-tax return from a portfolio of stocks may be increased if the investor engages in a consistent program of harvesting losses from depreciated stocks and realizing those losses using the specific identification method. For example, Berkin and Ye used Monte Carlo simulations to demonstrate a nontrivial increase in the after-tax rate of return from systematically harvesting losses in a timely manner and selling those blocks of shares with the highest basis. The study assumed that the investor was not constrained by the wash-sale rule. For taxpayers in the 20% tax bracket, over a 25-year period, their annual after-tax return was increased by .4% per year on average before a stock portfolio was liquidated and by .31% per year after the portfolio was liquidated.
Investors need to weigh non-tax factors before investing in stocks.
Directly investing in stocks provides the investor with certain tax advantages relative to investing in funds or ETFs. However, before directly investing in stocks, other factors should be considered. The investor needs to assess whether he or she has adequate time to research stocks and sufficient funds to maintain a diversified portfolio. To derive the tax benefits of direct investment in stocks, the investor needs to have the willingness and emotional detachment to regularly harvest losses and defer the realization of capital gains.
Conclusion
The major options available to an individual for equity investments are actively managed mutual funds, index mutual funds, ETFs, and direct investment in stocks. Under ATRA, upper income investors face significantly higher tax rates on equity capital gains and dividend income. Consequently, it is particularly important for this cohort of investors to give careful thought to the relative tax efficiency of these investment options.
Of the four major options listed above, actively managed funds are the least likely to meet the conditions of tax efficiency. This is primarily because the fund manager often engages in high portfolio turnover. As a result, an actively managed fund often fails to obtain significant deferral of capital gains and may unnecessarily generate short-term capital gains (passed through as ordinary income) and nonqualified dividends. Like all RICs, net capital losses generated from actively managed mutual funds are not passed through, but instead are carried forward.
Passively managed index funds, because their goal is to simply track a benchmark index and are less likely to experience net redemptions, normally trade stocks much less frequently than actively managed funds. Their slower portfolio turnover rate is likely to result in greater deferral of capital gains, fewer short-term capital gains, and a smaller percentage of dividends that are classified as nonqualified. In contrast to index mutual funds, passively managed ETFs are structured so that investors buy and sell shares in the open market rather than directly from the ETF. Consequently, when there are net redemptions, an ETF is not forced to redeem shares and thus possibly trigger capital gains for the remaining shareholders. At least marginally, passively managed ETFs that track broad market indexes have proven to be more tax efficient than passively managed index funds that track comparable indexes.
Investing directly in stocks confers several advantages over RICs, including ETFs. Capital losses may be harvested and used to immediately offset the investor’s capital gains as well as up to $3,000 of ordinary income. The investor may use the specific identification method to determine which lots to sell in light of the investor’s particular tax situation. Finally, for the charitably minded, the investor is more likely to identify highly appreciated equities from stocks than from RICs to give to charity.
