Higher Taxes? Consider Tax-Efficient Stock Investing

April 30, 2013

With taxes having been raised this year for the most affluent and surveys frequently showing that many expect to pay higher taxes in the future, tax-efficient investing may become more important for investors.

Of course, many investors already take advantage of such tax-advantaged accounts as individual retirement accounts (IRAs), Roth IRAs, 401(k) programs, and other workplace savings plans.

But those investing in taxable accounts—accounting for about half of all mutual fund assets nationally, according to the Lipper research firm—potentially face annual tax bills from distributions of funds’ short- and long-term capital gains and dividends.

The good news is that the latest comprehensive study by Lipper of mutual fund taxes shows that the tax drag on investors’ annual returns in the average equity fund trended downward during the 2001–2010 period.

Lipper attributes this to the Bush-era tax cuts and to many mutual funds’ having carried forward tax losses from selling during that decade’s two deep bear markets—losses that were used to offset the funds’ later capital gains.

The bad news is that, during the 2006–2010 period, investors in taxable equity mutual fund accounts still saw the average fund return trimmed 0.93 percentage points by taxes, the Lipper study noted.

Such tax expenses would be directly or indirectly funded—from fund redemptions or transfers from other accounts. (This annual tax drag may be somewhat mitigated when investors sell fund shares, as prior capital gain distributions reduce capital gains on sales.)

The trend of a falling tax burden may be temporary as the bear markets’ buildup of tax losses are rapidly being used up by many funds to offset gains realized during the recent rise in equity markets.

And then there are the recently increased tax rates on earned income and investment income for relatively wealthy investors.

In the booming equity markets of the late 1990s and the poor equity markets of the 2000s, investors may not have given much consideration to their mutual fund tax burden, says Don Peters, manager of the Tax-Efficient Equity Fund.

But with higher tax rates and the resurgence in equity performance, Mr. Peters says the differences between pretax and post-tax returns could widen in the future, and many investors may become more tax conscious.

“One of the most common mistakes that investors make is misunderstanding the potential losses associated with taxes,” he says. “If you compound a percentage point or two of difference between pretax and post-tax returns over a long period, that can be a significant difference in compounded wealth.”

Asset Location

To achieve greater tax efficiency, the place to start is with the question of asset location: Which assets should investors put in their tax-deferred accounts and which in their taxable accounts?

T. Rowe Price financial planners say that investors first should employ an overall investment strategy of linking the time horizons of their financial goals and their risk tolerances to appropriate asset allocations and to account types.

In most cases, that means using tax-deferred and tax-free accounts (such as Roth accounts) for retirement savings and using taxable accounts for shorter-term goals, emergency cash, and retirement savings beyond the limits of contributions to tax-advantaged accounts.

But after that level of planning, tax-conscious investors may want to consider putting investments that tend to spin off more dividends, such as bonds and fixed income and real estate funds, in their tax-advantaged accounts.

That generally would leave growth–oriented equity funds, money market funds, municipal bond funds, individual securities, and lower-turnover equity funds, such as tax-efficient funds and index funds, for investors’ taxable accounts.

Of course, this overall asset-location strategy mainly applies to those with assets in both taxable and tax-advantaged accounts.

Those with the bulk of their investments in tax-advantaged accounts may want to give greater weight to equity funds in these accounts, depending on their time horizons, because over the long term stocks have tended to outperform bonds.

However, investors should keep in mind that gains from equity funds in tax-deferred accounts would be taxed at a possibly higher ordinary income tax rate than the capital gains rate.

And of course, tax efficiency itself does not ensure higher returns, and there are many equity funds with low turnover rates that are relatively tax-efficient—without being branded as such.

For tax-conscious investors, however, tax-efficient investing “may make more sense than ever,” says Christine Fahlund, a T. Rowe Price senior financial planner.

“In today’s fast-moving markets, investors should be looking for ways to invest for the long term without having to make constant adjustments to their portfolios based on tax code changes that Congress may be making, and investing in a tax-efficient manner could be a big step toward that.”

Buy and Hold

Since its inception in 2000, the Tax-Efficient Equity Fund has been almost 100% tax-efficient.

The Tax-Efficient Equity Fund has passed on some of its dividends to shareholders—although, as a growth fund, it tends to have a relatively low dividend yield ratio.

But the fund has had no capital gain distributions since its inception because Mr. Peters has kept the fund’s turnover relatively low (about 26.4% for the 12 months ended March 31, 2013) and offset realized capital gains with losses harvested from tactical selling.

At the same time, he stresses, the Tax-Efficient Equity Fund is not managed purely with the goal of tax mitigation.

Rather, he follows a philosophy of steadily buying a broad range of high-quality mid- and large-cap companies at reasonable valuations and holding them for the long term.

“In order to minimize taxable capital gain distributions and maximize after-tax returns,” Mr. Peters says, “we plan to own our companies for the long haul, focusing on those with strong, sustainable market positions and high returns on capital. We prefer to let our winners run, rather than realize gains, unless the companies’ long-term outlooks have deteriorated.

“We believe market timing is virtually impossible. Attempts to sell at the peak and buy at the bottom require an investor to make the right timing decisions not once, but twice—complicating an already challenging task under any market conditions,” he says.

“So, although we may make new purchases opportunistically, we don’t trade opportunistically or rotate from one sector to another in an attempt to capture short-term outperformance.”

Such an approach requires patience both for the fund manager and fund investors, he says, as over the short term the fund’s performance may deviate positively or negatively from that of funds more focused on pretax returns.

For Mr. Peters, it also requires discipline to stick with stocks of high-quality companies with durable franchises that may be temporarily subjected to declines from short-term problems.

Such is the case with Boeing, the world’s leading aerospace company and one of the larger, long-term holdings in the fund.

Boeing’s share of a firmly entrenched global duopoly in the commercial aircraft business (along with Airbus) and its continuing strong financial conditions enabled Mr. Peters to see beyond the battery problems with the new 787 Dreamliner that cropped up at the beginning of the year. So he added to the fund’s holding of the stock.

“As a longer-term investor, it is inevitable that every company we own will go through periods of adversity,” he says. “We believe our advantages in evaluating such issues are twofold: T. Rowe Price’s global research platform and this particular fund’s longer time horizon for investing relative to others.”

Shares of the Boeing Company made up 1.4% of the Tax-Efficient Equity Fund as of March 31, 2013. European Aeronautic Defence and Space Co., parent of Airbus, was not held by the fund.  

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Fund holdings are subject to market risk, and share prices may be more volatile than those of a fund focusing on slower-growing or cyclical companies.