Personal Finance

How to Bring Structure to Your Portfolio

December 5, 2016
Using a tax-efficient approach to get the most from your investments.

Key Points

  • There are ways to improve a portfolio’s overall tax efficiency.
  • Investors with taxable and tax-advantaged accounts can consider what types of mutual funds they use in each.
  • Tax-efficient mutual funds specifically focus on after-tax returns and minimizing annual distributions.

Mutual funds can help individual investors benefit from professional management and broad diversification regardless of an investor’s assets. But investors should consider not only the types of funds they invest in but also the types of accounts in which to hold them—often referred to as asset location. The right asset location strategy could make a portfolio more tax-efficient and potentially improve your long-term returns.

Investors should always first consider their overall asset allocation to make sure it is consistent with their financial goals, time horizon, and risk tolerance, says Judith Ward, CFP®, a senior financial planner with T. Rowe Price. “Beyond that, it could be beneficial for long-term fund investors—particularly those in higher tax brackets—to develop an effective tax-diversification strategy.”

YOUR MUTUAL FUNDS AND TAXES

Both equity and bond funds must make dividend and capital gains distributions to shareholders each year, based on the interest and dividends they earn on their investments and any capital gains realized from the sale of securities. Taxes are due on such distributions in the year they are received. Some funds can avoid, or at least minimize, capital gain distributions if they are carrying losses on sales of securities in prior years that can be used to offset gains earned in current or future years (also known as tax loss carryforwards).

A mutual fund’s tax efficiency is less relevant when it’s held in a tax-advantaged account. After all, dividend and capital gains taxes are deferred if the funds are held in qualified, tax-sheltered plans such as an individual retirement account (IRA) or a 401(k) plan. But for those investors who use taxable accounts, taxes on dividends and capital gain distributions can become a drag on returns.

Various studies show that a fund’s average annual return could be trimmed by approximately two percentage points or more, depending on the type of fund, due to taxes on fund distributions.

“One of the most common mistakes that investors make is not appreciating how much returns could be undermined due to taxes,” Ward says. “Compounding a percentage point or two of difference between pretax and after-tax returns over a long period can be a significant difference in compounded wealth.” Also, with the increase in tax rates that took effect in 2013, taxes are taking a larger share of the investor’s return.

Compounding a percentage point or two of difference between pretax and after-tax returns over a long period can be a significant difference in compounded wealth.

- Judith Ward, CFP®, T. Rowe Price Senior Financial Planner

BECOMING MORE TAX-EFFICIENT

Creating a tax-efficient asset location strategy involves recognizing how the tax treatment of various assets differs. For instance, income-oriented investments such as taxable bonds and bond funds tend to trigger taxable events, meaning they might be better suited for tax-advantaged plans. On the other hand, municipal bonds, tax-efficient equity funds, and certain types of index funds are relatively tax-efficient already and so might be best held in a taxable account. (See Tax Efficiency for Various Fund Categories.)

Tax-efficient equity mutual funds are managed to minimize annual distributions and tend to have lower turnover rates than traditional actively managed equity funds. Tax-efficient equity funds are more focused on after-tax than pretax returns compared with equity funds generally.

In an effort to minimize capital gain distributions, the T. Rowe Price Tax-Efficient Equity Fund (PREFX) has maintained a significantly lower turnover rate relative to other actively managed growth funds by focusing on durable growth companies and taking a long-term approach. By limiting sales and harvesting losses from tactical selling, the fund can limit taxable realized gains. The fund’s goal is to maximize long-term after-tax wealth while taking a reasonable amount of risk, says Don Peters, the fund’s manager.

“Given our long time horizon, it’s almost inevitable that companies we own will go through periods of adversity,” Peters says. “But we prefer to let our winners run, rather than realize gains, unless a company’s long-term outlook has fundamentally deteriorated.”

Tax efficiency through asset location is a way to make the most of your current investment strategy. It doesn’t negate the benefits of maximizing the opportunities from your tax-advantaged savings accounts. “Take full advantage of tax-sheltered plans available and give first priority to establishing and maintaining a suitable asset allocation strategy,” Ward advises. “Beyond that, tax diversification and tax efficiency are important concepts that should be considered. After all, it’s not just how much you earn, but also how much you actually keep that is fundamental to a successful long-term investment program.”

Tax Efficiency for Various Fund Categories

Different types of funds can vary greatly in their tax efficiency, based on a combination of the strategy they pursue and the assets they hold.

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Based on annualized total returns for the 10-year period ended September 30, 2016.

Sources: Morningstar and T. Rowe Price.

The T. Rowe Price Tax-Efficient Equity Fund’s average annual total returns were 9.64%, 15.52%, and 8.15%, for the 1-, 5-, and 10-year periods ended September 30, 2016, respectively. The fund’s after-tax returns pre-liquidation were 9.50%, 15.12%, and 7.95% and the after-tax returns post-liquidation were 5.57%, 12.50%, and 6.64%.2

The fund’s expense ratio was 0.86% as of its fiscal year ended February 29, 2016.

Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or loss when you sell your shares. To obtain the most recent month-end performance, go to troweprice.com/tmc.

The performance information shown does not reflect the deduction of a 1% redemption fee on shares held less than 365 days. If it did, the performance would be lower.

The Tax-Efficient Equity Fund is subject to market risk, and the share price may be more volatile than that of a fund focusing on slower-growing or cyclical companies.

1Pre-Liquidation means before the sale of any shares. Post-Liquidation means after all shares are sold. Tax efficiency measures how much of a fund’s annual return is earned after taxes, so the higher the number the better. These data reflect taxes paid on annual dividends and capital gain distributions but assume that investors did not sell their shares at the end of this 10-year period.

2The returns presented reflect the return before taxes, the return after taxes on dividends and capital gain distributions, and the return after taxes on dividends, capital gain distributions, and gains (or losses) from the redemption of shares held for 1-, 5-, and 10-year or since-inception periods as applicable. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. The after-tax returns reflect the rates applicable to ordinary and qualified dividends and capital gains effective in 2003. During periods when the fund incurs a loss, the post-liquidation after-tax return may exceed the fund’s other returns because the loss generates a tax benefit that is factored into the result. An investor’s actual after-tax return will likely differ from those shown and depend on his or her tax situation. Past before- and after-tax returns do not necessarily indicate future performance.

Average annual total return figures include changes in principal value, reinvested dividends, and capital gain distributions.

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