Let me begin this post by saying I am not a tax professional, and I am hardly a tax expert. However, I do try to work closely with my clients’ tax professionals because taxes are a huge component of portfolio performance. That being said, one thing I’ve learned from working with these tax pros is that while many investors have more control over their tax situation than they realize, they spend too much time fretting over macro market forces beyond their control instead of trying to mitigate the deleterious effects of avoidable taxes on their portfolios’ performance.
Given the importance of taxes, I would like to show a real-life example of how allocating and planning with tax-efficiency in mind can be so valuable to clients.
With permission from a client, I am taking real-life data from her experience over a planning relationship that has spanned many years. Her prior planner had sold her a portfolio of fixed and variable annuities so that the bulk of her investments, – both qualified and non-qualified, – were tax-deferred. When this particular planner exited the industry, the client came to us, and we engaged her in a consulting type relationship on a hourly basis as there was little we could do until the annuities matured.
Once the annuities did mature, we transitioned the non-qualified funds into a brokerage to invest in such things as dividend paying stocks, muni ETFs, etc. The IRA composition has been almost entirely bonds paying taxable interest.
You can see from the data below (all actual data, mind you, presented with permission) the impact on the client’s tax situation once the annuities were phased out, and the tax-efficient strategies took effect:
Compare, for example, the circled cells in years 2009 and 2010. In 2009, IRA distributions along with pensions and annuities totaled $22,273; in 2014, those amounts were $14,390, but the client also received $8,662 in dividends ($8,560 of which were qualified), so the total in cash portfolio cash flow income was $23,052. Not only was that amount greater than in 2009, the client’s effective tax rate dropped from 8.36% to 4.93%, largely as a result of that.
Comparing 2010 and 2015 is equally instructive. In 2010, the client’s took extra money from her IRA, and also had $15,695 in pension and annuities, totaling $27,695. Last year, her IRAs and pension generated $14,390, and she received more than $10,000 in dividends. The total portfolio income was a bit less than in 2011, but because she prudently harvested some losses in her portfolio (and a had a bit more in deductions, etc), her effective tax rate went from 9.36% in 2011 to negligible.
Overall, the impact of tax-efficient investing has been pretty dramatic: the client’s income (in terms of total checks received) increased almost 20% from 2009 to 2015, but because of the composition of her income, – more qualified dividends, less ordinary income, – her total income for tax considerations dropped, largely the result of such things as having less of her Social Security be taxable. Obviously, minor things such as tax loss harvesting had a positive impact as well. These relatively minor changes, along with a small increase in deductions and exemptions, reduced taxable income 33%, resulting in a negligible tax obligation.
What’s interesting is that the dividend income has really exploded, and, because the client has stayed at or below the 15% marginal tax bracket over this period, her qualified dividends (as well as her capital gains) have not been taxed. What’s more, when the client passes away and leaves her taxable account to her children, they will receive the assets at a stepped up basis, meaning, essentially, a tax-free transfer between generations. This is quite unlike the non-qualified annuity contracts, the interest accrued on which would have been taxable as ordinary income to the beneficiaries.
My colleague, Dennis Wallace, has a mantra that investment success is a function of three things: returns, fees, and taxation. Experienced investors know that returns are the product of appropriate exposure, allocation, and patience. Fees, of course, should be kept to a minimum, and this is largely a result of investment product selection. Taxation, then, is a factor that too many ignore for whatever reason. Hopefully, this example will show that investors have more control over it than they think.
Obviously, all tax, investment, and portfolio situations are unique. Investors should consult their tax and investment professionals to see how their portfolios could be constructed in a more tax-efficient manner. Different circumstances could lead to different results.