OCEAN CITY — Of all of the variables that could affect investment returns in the months and years ahead, we believe one of the most certain is rising taxes.
While inflation should always be the number one concern for those seeking to protect against the eroding effect that non-investment factors have on returns, taxation is a close second.
It’s important to put this into perspective. Say you have a portfolio that generates an average 10% annual return over time, and that a good portion of that return comes from the appreciation of assets that are periodically sold and reinvested — and therefore subject to the tax on capital gains. At the current federal long-term capital-gains rate, that 10%
return is reduced by 15%, to 8.5%. If the portfolio has a great deal of turnover every year, and has to pay the top short-term capital-gains tax of 35% on a portion of the proceeds, the return drops to 6.5%. And if the portfolio contains taxable bonds and other sources of investment income subject to the top ordinary income rate, the return on that portion also drops to 6.5%. Add in state and local taxes, and you get the picture — taxes bite into returns even in a stable, high-growth environment where pre-tax annual returns of 10% are expected and taxes aren’t going up.
In reality, of course, returns of 10% have been anything but a given, and, in our view, taxes on investments and income are likely headed higher in coming years. We base this in part on the looming expiration of the 2001 and 2003 tax cuts, scheduled for the end of 2012 and in part on the dire fiscal imbalances facing the country.
For those who own businesses, corporate pension plans, also known as defined-benefit plans, offer another way to shield a portion of investment income and gains from taxes. Like annuities, corporate pension plans provide guaranteed income in the future and protect the growth of assets inside the pension from taxes.
Unlike annuities, business owners can contribute pre-tax dollars to defined-benefit plans.
If investors have already shielded their assets at a portfolio-wide level as much as is feasible, they can turn to minimizing taxes on specific asset classes and investments. They can try to generate more of their investment income from municipal bonds, whose income is currently free from federal and most state taxes. They can also generally try to focus more on investing for the long term.
Since long-term capital gains rates are likely to remain quite a bit lower than short-term gains or income rates, an investor can avoid the highest rates simply by holding investments for more than one year, at which time they generally are classified as “long-term.”
It’s clear that the time to proactively start planning for higher rates has come. The good news is that investors have a range of strategies to take advantage of. Traditional retirement plans that shield taxes — like IRAs, annuities and defined-benefit plans — deserve a new look for the role they can play in more affluent investors’ wealth allocation. Neutralizing taxes at the investment level is a time-tested strategy, but requires attention to all applicable tax laws and a thoughtful approach that combines active tax management of positions with overall risk management of the portfolio. Lastly, managing fees will also serve investors well in a low-return, higher-tax environment.
In the end, our best advice is also a time-tested one: diversify. By embarking on multiple strategies to manage tax burdens, much in the same way portfolios are diversified to manage risk, investors will be able to
weather all the uncertainty — as well as the certainty of taxes.
(The writer is a senior financial advisor and can be reached at 410-213-8521.)