Investors often inhibit their own investment returns by focusing too heavily on taxes. A potential consequence of a “tax efficient” focus is an investor’s portfolio having a greater level of risk while delivering lower rates of return.
Before we look at examples of how a “tax efficient” focus could undermine the balance between risk and return, let’s review where returns come from and how those returns are taxed.
Generally, investment returns come from capital appreciation, dividends, and interest income. Nonqualified dividends and interest income are taxed as ordinary income and, therefore, taxed at an investor’s marginal rate—as high as 37%. Qualified dividends receive preferential tax treatment and are taxed at 0%, 15%, or 20%. Whether a dividend qualifies for the lower tax rates depends on an investor’s total taxable income and filing status.
Interest Income
Since interest income is taxed at the investor’s marginal tax rate, managing the tax efficiency of interest income is pretty straightforward. A taxable equivalent yield formula is used to evaluate whether an investor, given their specific marginal tax rate, would benefit from “tax-free” municipal securities that pay a lower rate of interest or if they would benefit more by owning securities that pay taxable interest as their after-tax interest may exceed the tax-free interest received. The determination is largely driven by the investor’s marginal tax rate—the higher the marginal tax rate, the more beneficial “tax-free” interest will be.
Dividends
Managing the tax efficiency of dividends generated by equity investments is far more complex. What makes dividends more challenging is that the dividend is related to an equity security—having no maturity date, no par value, and no contractual obligation to pay dividends at a given rate or over a given period. In short, there are far more variables when attempting to manage the “tax efficiency” of dividends from equity investments.
The surest way to avoid paying taxes on dividends is to simply avoid owning stocks that pay dividends. Although this would appear to achieve ultimate “tax efficiency” as it relates to dividends, it would also eliminate many of the largest, most profitable, and best-performing stocks from an investor’s portfolio (e.g., Apple, Microsoft, Visa, Meta, Eli Lilly, Exxon Mobile, Chevron, Merck, etc., etc., etc.) Eliminating dividends in order to increase “tax efficiency” in your investments can degrade the return potential of a portfolio—both pre-tax and after-tax returns.
Some investment managers will manage for dividend “tax efficiency” by targeted removal of dividend-paying stocks from a broad-based index. For example, Vanguard’s Tax-Managed Capital Appreciation Fund (VTCLX) reduces the dividend yield by broadening the fund’s holdings into non-yielding stocks. Given the fund’s name, it is often inferred by investors to be a tax-efficient alternative to an S&P 500 index fund as the yield is slightly lower; therefore, the taxes associated with the dividends are lower. While the Vanguard 500 Index Fund (VFIAX) has a yield of 1.38% (as of 1/31/2024), the Vanguard Tax-Managed Capital Appreciation fund has a yield of 1.17% (as of 1/31/2024).
It’s important not to ascribe a “tax-managed” strategy to an investment simply because it is marketed as “tax-managed,” “tax-efficient,” “tax-sensitive,” etc. It’s important to open the hood and take a good look.
Capital Gains
A capital gain occurs as a result of the price appreciation of shares. A stock purchased for $10 that appreciates to a share price of $25 has a capital gain of $15. If the shares are not sold, the gain is referred to as an “unrealized gain,” and therefore the appreciation is not taxable. The appreciation of shares is only taxable in the event of a sale of shares. In the above example, a sale of shares at $25 would result in a “realized gain” of $15 per share, and the $15 of realized gain would be subject to applicable capital gains taxes.
In brief, the taxes owed on “realized gains” are determined by how long you owned the shares before they were sold and your tax bracket. Long-term capital gain rates apply to securities held more than a year, while short-term capital gains rates apply to securities held one year or less. Long-term capital gains receive preferential tax treatment, while short-term capital gains are taxed at the investor’s marginal rate. Important Note: Short-term capital gains rates can push an investor into a higher tax bracket, but long-term capital gains cannot.
| Filing Status | 0% Rate | 15% Rate | 20% Rate |
|---|---|---|---|
| Single | $0-$44,625 | $44,626-$492,300 | $492,301 + |
| Joint | $0-$89,250 | $89,251-$553,850 | $553,851 + |
| Head of Household | $0-$59,750 | $59,751-$523,050 | $523,050 + |
| Married Filing Separately | $0-$44,265 | $44,266-$276,900 | $276,901 + |
Very often, investors will avoid selling appreciated securities in order to avoid realizing a capital gain resulting in a capital gains tax. This is especially the case when investors own highly appreciated securities. Although the taxes on the gains of securities held longer than a year would be limited to no more than 20%, and for the vast majority of investors, no more than 15%, investors tend to think in dollar amounts when paying capital gains taxes, not percentages. This often leads to investors retaining highly concentrated stock positions in their portfolios, thus greatly adding to the level of risk and the probability of experiencing a large and potentially catastrophic loss.
Enron, CIT Group, WorldCom, Washington Mutual, and Lehman Brothers are just a few examples of once revered, award-winning companies with stellar performing stocks that went bankrupt. Over the past 20 years scores of large reputable companies have seen their share price tumble and not recover, even in an extended bull market. The once venerable General Electric—although it has recovered from its November 2019 lows—sports a current stock price that is still less than half the value it was over 20 years ago.
In short, paying 15% or 20% long-term capital gains tax on a realized gain can be far more attractive than holding on to a stock simply to avoid taxes. Professional mutual fund managers who manage aggressive growth portfolios rarely have a single stock accounting for more than 10% of their portfolio. Should you? If so, it should be for reasons other than solely to avoid taxes.
That said, taxes are an important consideration when making investment decisions. But taxes are only one of the many factors that need to be considered when managing an investment portfolio. The important point is, don’t let the tail wag the dog. Focusing too heavily on avoiding investment-related taxes can distort your investment strategy and expose you to far more risk than you should be. Systematic tax-loss harvesting (realizing losses in order to off-set gains) is an effective way to take advantage of tax efficiencies without taxes dominating your decision making, exposing you to needless risk, and potentially undermining your investment performance.