OCEAN CITY — U.S. equities are on track for their sixth consecutive year of positive performance, with five of those years bringing double-digit gains. Bonds have also had a strong year, leaving commodities as the only broad asset class in the red for 2014.
Given this strong performance, as well as the multitude of changes to the tax code last year, we think tax-aware investing remains a top priority for many investors.
Year-end tax-planning strategies can help manage current year capital gains, but maintaining tax-efficient strategies is critical for investors with longer-term goals. In our view, tax management as part of a disciplined portfolio management process can be an effective way of enhancing after-tax returns.
Taxes can significantly erode investment returns, potentially costing investors two to three percentage points annually. Tax-efficient investing does not have to be complicated and can be achieved through some simple considerations.
While by no means an exhaustive list, these steps provide a starting point for discussions with financial and tax advisors on how to incorporate tax management into investment planning.
Start with basics such as asset location. Asset allocation remains the primary driver of investment returns over the long term. Beyond that, wealth structuring is an important consideration in financial planning. Asset location, or where to place investment products, is a simple but an important one as well. In general, investors should hold tax-exempt securities such as municipal bonds in regular brokerage accounts. Longer-term investments should be held in tax advantaged retirement accounts, where realized capital gains or distributed income can compound over time at a higher tax-free rate.
Traditional municipal bonds provide a tax benefit as their coupon payments are exempt from federal taxes, and we believe the rules around this are unlikely to change in the near term.
Mutual funds vary by the amount of gains they generate due to the degree of active fund management. The rate of turnover in a fund’s holdings is therefore an important consideration when choosing one. In addition, mutual funds typically meet redemptions by liquidating portfolio holdings and distributing proceeds.
Exchange-traded funds (ETFs) are generally considered to be more tax-efficient than mutual funds due to the use of in-kind redemptions. They allow non-redeeming investors to avoid realizing capital gains. Another potential solution is investing in separately managed accounts (SMAs), which allow a portfolio manager to take advantage of tax-loss harvesting — selling holdings that have depreciated in value to help offset realized gains on others. This can help reduce the total tax bill for a portfolio.
Master Limited Partnerships (MLPs) have grown in popularity given their exposure to the resurgence in U.S. energy production, as well as steady cash flows and tax-efficient distributions. An MLP security generates a K-1 statement, which can be cumbersome for tax filing. However, certain managed vehicles can minimize the paperwork necessary when investing in this sector.
Investors may be able to realize tax benefits by considering the prices paid for individual lots of a holding. This is particularly true for a large position in a stock built over time.
In addition, while tax-loss harvesting cannot fully compensate investors for losses taken, when properly applied it can be used to reduce capital gains and a limited amount of ordinary income (up to $3,000 per year) for tax purposes, both currently and in future years.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)