IRS

The Tax Man Cometh

IRS

As fiduciaries for wealth, we at Index Fund Advisors are obligated to do everything we can to maximize our client’s after-tax returns. Please note that this is not always the same thing as minimizing taxes, but with the 2013 increase in tax rates (including the new 3.8% Medicare tax), tax awareness has become more important than ever. Here are the primary ways that we strive to accomplish this objective.

Tax-Managed Passive Funds with Low Turnover

The most obvious way to avoid a high tax bill is to avoid funds with high turnover which is something usually associated with active management. IFA advises the use of tax-managed funds in five different asset classes that comprise 70% of the equity allocation of a standard IFA portfolio. The table below shows the funds that IFA advises in each Morningstar category.

The bar chart below shows how these funds compare to their respective Morningstar categories with respect to turnover.

The two charts below show the resulting DFA advantage with respect to the after-tax return and the growth of wealth.

 

There are certainly other reasons behind the difference in after-tax returns such as fund expense ratios and the absence of loads from the DFA funds, and these factors are carefully considered when IFA chooses to advise the use of a particular investment vehicle.

Asset Location

For an investor who has both tax-qualified and non-qualified accounts, it is usually advantageous to place the less tax efficient asset classes such as real estate and fixed income in tax-deferred accounts while placing the more tax-efficient asset classes in taxable accounts, especially when tax-managed funds can be used for those asset classes. As for completely tax-free accounts, IFA advises putting in the asset classes with the highest expected returns such as emerging markets. Of course, the extent of the tax advantage gained from asset location depends on the size of each type of account as well as the overall asset allocation. If you currently using an advisor that does not take asset location into consideration (and we know that there are some advisors who do not from viewing their client’s account statements), you may want to consider getting a new advisor.

Tax Loss Harvesting

Tax loss harvesting is selling funds in order to realize a loss that can be used against future gains. It is the lemonade you make when the market hands you a lemon (a drop of 10% or more from the purchase price). Again, not all investment advisors consider it worthwhile because they claim that it simply lowers the cost basis, meaning that the gain will still have to be eventually recognized, and perhaps tax rates will be higher when it is. Since IFA’s “no forecast” approach to investing includes tax rates, IFA’s advice is to take tax losses whenever they are available for the taking. Furthermore, it is IFA’s opinion that delayed recognition of a gain is worthwhile due to the time value of money. Besides, if the account owner passes away, there is a step-up in basis for the heirs, so they would not get stuck with a gain should they decide to sell the fund.

Postponement of Mutual Fund Purchases

Mutual funds tend to distribute their realized capital gains towards the end of the year. For a buyer of the fund, that can mean incurring a tax liability for a gain in which he did not participate. Thus, it often makes sense to delay purchase beyond the record date for the distribution. For new purchases in taxable accounts, IFA carefully considers the expected return (approximated by the average return over the last 50 years) versus the estimated tax liability and chooses an appropriate date for halting purchases.

Below is a table for the distributions of December, 2013 indicating when IFA expects to cease making major purchases of funds in taxable accounts per the criteria stated in the above paragraph. These dates may vary for individual clients, depending on client situations. These dates are also subject to change based on information that may be received prior to the distribution dates.

Conclusion

Navigating through the complexity of today’s tax rates and regulations, it is vitally important to have the guidance of a fiduciary advisor. IFA will continue to stay abreast of developments in this area. If you have any questions or concerns about the impact of taxes on your investments, please feel free to call us at 888-643-3133.