- Principle 1: When saving for retirement, individuals should maximize contributions to Roth IRA and qualified retirement accounts like the 401(k). This principle was discussed in the February 2005 issue.
- Principle 2: When managing stocks in taxable accounts, individuals should aggressively realize capital losses (that are large enough to offset transaction costs) and hold onto unrealized capital gains. This is the subject of my current article.
- Principle 3: When possible, while attaining the desired asset allocation, individuals should place bonds in retirement accounts and stocks, especially passively held stocks, in taxable accounts (with the exception of liquidity reserves, which should be held in taxable accounts). This will be covered in my next column, which will appear in the November 2005 issue of the AAII Journal.
- The trader: This investor realizes all gains each year as short-term gains and pays taxes at 28%. He earns a 5.04% aftertax rate of return [7% × (1 0.28)]. His aftertax wealth is $1,279 after five years and $3,419 after 25 years.
- The active investor: This investor realizes all gains as soon as they are eligible for long-term capital gains tax treatment—that is, in one year and one day. Each year he pays taxes at 15% on realized gains. He does not benefit from allowing gains to grow unrealized or, as I prefer to say, unharvested. He earns a 5.95% aftertax rate of return [7% × (1 0.15)]. His aftertax wealth is $1,335 after five years and $4,242 after 25 years.
- The passive investor: This investor buys and holds stocks until the end of the planning horizon. At withdrawal, capital gains are realized and taxed at 15%. Unlike the active investor, the passive investor benefits from allowing capital gains to grow unharvested. She earns a 7% return, which after five years grows to $1,403, a capital gain of $403 [$1,403 $1,000]; at withdrawal, the $403 capital gain is taxed at 15%. Her aftertax wealth is $1,342 after five years and $4,763 after 25 years.
- The exempt investor: This investor is a special case of the passive investor. For this investor, capital gains are tax exempt, which occurs under two circumstances: Stocks receive a step-up in basis at the death of the owner; and capital gains are tax exempt if the appreciated asset is given to charity. [For examples of how this works, see the related sidebar below.] In the example in Table 1, the exempt investor earns a 7% annual rate of return, with no taxes due—the aftertax return is equivalent to the pretax return, and the investor gets to keep everything.
- After 25 years, the median advantage from loss harvesting is nearly 20%, or 0.8% per year. Todays lower capital gains tax rates suggest smaller, but still sizeable, advantages.
- A great deal of loss harvesting occurs in the first few years. After five years or so there were usually relatively few losses to harvest, since remaining stocks usually had sizable unrealized gains. Thus, a disproportionate share of the tax benefits from loss harvesting occurs in the first few years.
- The tax advantage from loss harvesting is usually relatively strong when market returns are poor, since poor returns create opportunities to realize losses.
- Allow capital gains to grow unharvested. Unless there are offsetting short-term losses, the gains should be held at least long enough to qualify for preferential capital gains tax rates. Better yet, they should be deferred for many years. Ideally from a tax-efficiency perspective, the gains should be held until they receive the step-up in basis at death or the appreciated asset is used to satisfy charitable intentions. Your stock management strategy can have a substantial effect on the aftertax return you earn on stocks held in taxable accounts.
- Aggressively harvest capital losses (that are large enough to offset transaction costs). In essence, the government shares in realized losses on assets held in taxable accounts. The loss can either be used to offset capital gains or used to offset up to $3,000 per year in taxable income. Unused losses in any year can be carried forward to future years.
The Great Tax Fight: Managing Stocks in Taxable Accounts
by William Reichenstein
Which challenger has fared best against Uncle Sam?
The Tax-Efficient Investor, who is able to use the tax code to best advantage.
This is the second of three related articles on the broad topic of tax efficiency. Based on reader feedback, there is substantial interest in this topic.
My series, even though it keeps expanding, only addresses part of tax-efficient investing topics. In this series, I assume there are two assets—stocks and bonds—that can be held in one of two locations—taxable accounts or retirement accounts, including Roth IRAs and qualified retirement accounts like the 401(k). My advice is limited to this framework.
The series establishes three tax-efficient principles:
The principle to be established in this article is that individuals should aggressively realize capital losses (that are large enough to offset transaction costs) and hold onto unrealized capital gains.
In general, stocks produce capital gains, while bonds produce interest income with limited ability to realize capital gains. If a bond is bought at par and held to maturity, all returns are in the form of interest payments. Consequently, I assume that the underlying asset in which an investor will wrestle with tax issues is stocks or stock funds (or some other asset with substantial capital gain potential).
The tax treatment of stocks held in taxable accounts depends upon the split between dividends and capital gains and, more importantly in regards to tax efficiency, it depends upon how long the investor holds the gains before they are realized. That is, tax efficiency depends on the individuals stock management style.
The good news is that you can control your stock management style.
Active vs. Passive Management Lets assume four individuals invest $1,000 each in stocks held in a taxable account. The stocks earn 7% per year, all in the form of capital gains, the ordinary income tax rate for these investors is 28% and the capital gains tax rate is 15%.
Table 1 presents the aftertax ending wealth values for these investors, each of whom has a different stock management style.
|TABLE 1. Aftertax Ending Wealth for Four Stock Investors by Investment Horizon|
|Stock Management Style||5 Years||10 Years||15 Years||20 Years||25 Years||30 Years|
|Total Knockout: How Capital Gains Can Become Tax Exempt|
In the Great Tax Fight with Uncle Sam, there are two circumstances under which you can achieve a total knockout and completely avoid taxes on unrealized capital gains.
The first circumstance is upon the death of the stock owner. In this instance, stocks receive a step-up in basis at death. As an example, assume a married couple invested $1,000 in stocks 20 years earlier, and its market value is now $3,870. However, the husband suddenly dies.
If the couple lives in a community property state, at the husbands death the cost basis rises to $3,870, so the surviving wife could sell the stock and avoid taxes on 20 years of price appreciation.
If the couple lives in a common-law state, the cost basis would rise to $2,435—that is, the step-up in basis is half the price appreciation. The key is that only assets held in taxable accounts receive this step-up in basis. This is one feature of the tax code that favors holding assets with capital gain potential in taxable accounts.
The second instance in which unrealized capital gains are tax exempt is if the appreciated asset is given to charity. Lets return to the prior example of the couple with stock worth $3,870, but it has a cost basis of $1,000. The couple could sell the stock, pay capital gains taxes, and give the remainder to charity. In this instance, they would deduct the aftertax proceeds of about $3,439.
Instead, a better strategy would be to give the appreciated stock to charity. In this case, they would deduct from taxable income the $3,870 market value. The charity can sell the stock and, if it has tax-exempt status, avoid paying taxes on the capital gains.
Giving the appreciated asset to charity is a win-win strategy. The donor gets a larger tax deduction and the charity receives a larger gift.
Although the trader, active investor, passive investor, and exempt investor are only hypothetical investors, the ending wealth values in Table 1 provide important insights into tax efficiency.
Passive Advantage In general, the more passive the better. First, the advantage of the active investor compared to the trader is that he benefits from the preferential 15% capital gains tax rate. As long as long-term capital gains receive preferential tax rates, investors should hesitate to realize short-term gains. An exception would be someone who has offsetting losses.
Second, the advantage of the passive investor compared to the active investor is that she benefits from allowing capital gains to grow unharvested until the end of the investment horizon. This tax-deferral advantage is relatively small over short horizons—for example, $7 after five years—but it is relatively large at long horizons—for example, $521 after 25 years. The lesson is that individuals should try to let capital gains grow unharvested for long horizons.
Third, the advantage of the exempt investor compared to the passive investor is that the capital gains are eventually tax exempt. Obviously, not everyone is in a position to await the step-up in basis or give appreciated assets to charity. But it is a wonderful, tax-efficient strategy for those who are in such a position.
The ending wealth values inTable 1 illustrate that an individuals stock management style has a major influence on his or her aftertax ending wealth. When possible, capital gains should be allowed to grow unharvested for at least a year and a day and preferably for decades.
The Active Management Burden
It is well-known that passive mutual funds usually beat active mutual funds. Active funds have a hard time overcoming the twin disadvantages of higher expense ratios and higher transaction costs.
Individual investors face a similar situation: When managing stocks in taxable accounts, active management must overcome these two hurdles, plus the third burden of higher taxes due to the quicker realization of gains.
Table 2 illustrates this point. It assumes stocks earn 7% gross returns per year, all capital gains. This implicitly assumes that active managers do not add any value through security selection, so gross returns are equal for the actively managed and passively managed funds.
|TABLE 2. Three Stock Management Burdens: Active vs. Passive|
|Pretax Net Return||5.50%||6.60%|
|Aftertax Net Return||4.48%||6.06%|
The actively managed stock portfolio has expenses of 1% annually, and incurs 0.5% in annual transaction costs, so its pretax net return is 5.5%.
The passively managed stock portfolio has expenses of 0.3% annually, and incurs annual transaction costs of 0.1%, so its pretax net return is 6.6%.
If you are actively managing your own stocks, your management skills must be good enough to overcome at least these two burdens—and remember, professional mutual fund portfolio managers have had a hard time doing so historically.
If your managed stock holdings are in retirement accounts, then you only need be concerned with these two burdens.
However, if you are managing your stocks in taxable accounts, you also must consider the additional tax burden of active management.
Table 2 assumes that the tax burden of the actively managed stock portfolio is 1.02%; it realizes 1.5% of short-term gains each year that are taxed at 28% and 4% of long-term gains (held one year and one day) that are taxed at 15%.
The passively managed stock portfolio allows gains to grow unharvested for 25 years and then realizes the gains and pays taxes at the preferential 15% tax rate. The annual aftertax return is 6.06%, so the tax burden is 0.54%. If the passively managed stock portfolio were held until it received the step-up in basis, or were used to fund charitable desires, then there would be no tax burden.
Many investment professionals complain that passive stock management is a hard strategy to sell. Clients question why they are being charged thousands of dollars in fees when few trades are being made.
Letting gains grow unharvested may be a tough sell for professionals, but it is a valuable lesson for taxable investors. When you sell a stock or stock fund with a built-in gain and replace it with another, you incur a certain tax burden for the uncertain hope that the replacement stock or stock fund will have a higher return.
Time Increases the Burden
It is clear from these examples that an active investor must bring some significant skills to the ring in order to overcome the tax burdens imposed by the management style.
How good do you need to be to overcome these burdens?
Table 3 presents the additional pretax return by investment horizon that an active investor must earn in order to earn the same aftertax rate of return as a passive or an exempt investor.
|TABLE 3. Annual Tax Burden by Horizon for Active Investors|
|Horizon||Avs. Exempt Inv
(Mkt Val = Basis)
vs. Exempt Inv
vs. Passive Inv
|(Market Value = 2 × Basis)|
In Column A, the stocks market value equals its cost basis. In Columns B and C, the stocks market value is twice its cost basis.
Columns A and B present the additional annual pretax returns an active investor must earn compared to an exempt investor to produce the same aftertax return. Column C presents the additional annual pretax return an active investor must earn compared to a passive investor when the stock contains substantial unrealized capital gains.
Capital gains tax rate is 15%.
It uses the active investor as the comparison because most investors realize gains within a few years and are most like this investor. It assumes the passive or exempt investor continues to earn 7% per year, and it asks how much additional pretax return the active investor must earn to offset the tax burden.
Column A assumes the underlying asset is stocks with no unharvested gains—that is, its cost basis is equal to its market value. If the exempt investor earns 7% a year, then the active investor must earn 8.24% [7% ÷ (1 0.15)], or an additional 1.24% per year, just to offset the tax burden. In this situation, this tax burden is the same for all horizons.
Columns B and C assume that the underlying asset is stock with a market value that is twice its cost basis. For example, the market value might be $4,000 with a $2,000 cost basis. Column B assumes that the non-active investor is also completely tax exempt, while Column C assumes the non-active investor will eventually pay capital gains taxes.
In Column B, the exempt investor holds the stock and continues to earn 7% per year, and the gain is eventually tax exempt at the end of the investment horizon. In contrast, the active investor must sell the appreciated stock and pay taxes on the built-in gain at the 15% tax rate. In addition, this active investor realizes gains each year thereafter and pays taxes at 15%. Column B shows the additional return necessary to offset the tax burden.
For a one-year horizon, the burden is an insurmountable 11.44%. It implies that someone who will die in about one year—perhaps someone with terminal cancer—should do everything feasible to hold on to assets with appreciable capital gains and await the step-up in basis. As the horizon lengthens, the tax burden decreases, but it remains virtually insurmountable. For example, it is virtually impossible to find a stock fund that can outperform its benchmark by 2.22% per year for as long as 10 years.
This suggests that investors who hold assets with substantial unrealized gains (and do not need to sell these assets for spending money) should try to await the step-up in basis or use the appreciated asset to finance charitable desires.
Column C presents the situation for someone who will eventually realize the unharvested gain and pay taxes at 15%.
For this investor, the question is whether the stock should be sold and taxes paid today or whether the stock should be sold later and taxes paid later.
Not surprisingly, everything else being equal, it is better to sell later and pay the taxes later. But look at the difference time makes!
If the investment horizon is one year, then the tax burden on the active investor is only 0.57%.
As the horizon lengthens, the tax burden increases, although it never approaches the levels in Column B. Realizing the gain today instead of in 10 years creates a tax burden of about 0.72% per year. This may not sound like much, but the history of active stock management indicates that few managers can consistently pick stocks that add 0.72% or more per year in value compared to returns on a same-style index fund. Consequently, the benefits of continued tax deferral are not trivial.
Tax-Efficient Stock Funds
These tables demonstrate the significant advantages that tax-efficient mutual funds provide. Good candidates for tax-efficient funds are tax-managed stock funds, large-cap index funds, and total-market stock index funds. Since the goal of tax-managed funds is to not realize net capital gains, these funds should be tax efficient. Index funds that follow the large-cap indexes like S&P 500 or Russell 1000 or total-market indexes like Wilshire 5000 or Russell 3000 are tax efficient. Furthermore, each of these choices provides a good core stock portfolio that should serve everyones portfolio.
In contrast, small-cap and mid-cap index funds are not as tax efficient, since managers of these funds will have to sell their biggest winning stocks that grow too large for the index.
For example, the Russell 2000 contains the 1,001st to 3,000th largest-cap stocks. Ten years from now, perhaps the best-performing 600 stocks will grow too large for this small-cap index, so the manager will be forced to sell these winners and realize the gains.
Similarly, stock indexes that follow the value or growth half of an index are less efficient since many stocks migrate between these halves through the years. To be truly tax efficient, you want to let unrealized gains grow unharvested for decades.
The Value of Loss Harvesting
Of course, if you are managing your own stock portfolio you can add one other section of the tax code to your arsenal: loss deductions. This section emphasizes the importance of realizing losses. We begin by discussing another stock management style, that of a tax-aware investor. She is similar to buy-and-hold passive and exempt investors in that she allows gains to grow unharvested, but she aggressively harvests losses.
Table 4 shows the advantage of loss harvesting. It assumes an original $1,000 investment in a stock that loses 25% the first year, and then gains 7% per year each year thereafter.
|TABLE 4. Aftertax Wealth for Buy-and-Hold vs. Tax-Aware Investors by Investment Horizon|
|In this table, each investor buys a stock for $1,000. The stocks value falls to $750 the first year, and grows at 7% per year thereafter. The buy-and-hold investor does not realize the capital loss after the first year; the tax-aware investor realizes the $250 loss, which saves her $70 in taxes that year. She invests the $820 ($750 proceeds plus the $70 tax savings) in another stock that earns 7% per year. The ending values assume the capital gains are eventually tax exempt.|
The buy-and-hold investor does not realize the loss after the first year nor gains in later years. After the first year, the investment is worth $750. After five years, it is worth $983. After 25 years, it is worth $3,804.
The tax-aware investor also invests $1,000, but after the first year she sells the stock at $750 and uses the $250 loss to offset taxable income. The $250 loss saves her $70 in taxes since she is in the 28% tax bracket [$250 × 0.28]. So, after the first year the investment is worth $820 after the tax savings. It is reinvested in another stock that earns 7% per year thereafter. After five years, her investment is worth $1,075. After 25 years, it is worth $4,159.
At every investment horizon, the tax-aware investors value is about 9.3% higher than that of the buy-and-hold investor. The tax savings increases the ending first-year value by 9.3% or $70 ÷ $750, and since subsequent returns are the same, the tax-aware investor always has 9.3% more wealth. The values in Table 4 assume the gains are eventually tax exempt for both investors. If taxes are eventually paid on the gains, the aftertax difference would be less than 9.3%, but the tax-aware investor would still have the larger aftertax ending wealth.
The key insight is that the government stands ready to share realized losses on assets held in taxable accounts. By harvesting losses, the government bears part of the loss. Furthermore, the government shares the losses precisely when the help is needed most—when returns are poor. This is another feature of the tax code that favors holding stocks (and other assets with potential for substantial capital gains) in taxable accounts.
[Keep in mind, however, the tax rules. Capital losses first reduce gains (with long-term losses reducing long-term gains first and short-term losses reducing short-term gains first). Losses that remain after offsetting capital gains can reduce ordinary income by up to $3,000 a year; losses above that amount can be carried forward to future years until they are used up.]
Gains From Loss Harvesting
To estimate the likely gains from tax-loss harvesting, I turn to several academic studies by Profs. Arnott, Berkin, and Ye. In one study, they ran 400 simulations of a 500-stock portfolio when held for 25 years. They assume the stock market earns, on average, about 8% per year, including about 1.8% dividend yield. Each year, the stock markets actual return could deviate substantially from this average. In addition, each individual stocks return could deviate substantially from that years market return. The simulations produced 400 separate 25-year possible histories, ranging from the worst of times to the best of times.
For each simulation, the researchers monitored two portfolios: a buy-and-hold portfolio and a tax-advantaged portfolio. The latter harvests losses whenever possible and assumes the proceeds are reinvested in another stock. They calculated the ending wealth advantage of the tax-advantaged portfolio after liquidation and paying taxes on deferred returns. They assumed the investor is in a combined federal-plus-state 35% tax bracket. The study reached the following conclusions:
Let me give a real example of how tax-aware investing can work.
A 40-something couple had already saved all they could in Roth IRAs and qualified retirement accounts. In late 2001, they had an additional $50,000 to invest, and invested the funds in a tax-efficient stock index fund.
One year later, after the stock market declined, the value of the fund was worth $41,000. The couple sold the fund and bought a tax-managed stock fund. The couple was able to write off $3,000 per year in losses against taxable income for 2002 through 2004. The value of the investment is currently worth about $57,000 today.
Since the stock fund now has a substantial built-in capital gain, it is unlikely that this couple will be able to harvest additional losses on these funds. The couple anticipates awaiting the step-up in basis after the death of the first spouse—perhaps 25 years hence. At that time, the fund may be worth $300,000. The surviving spouse can then sell the fund and use the proceeds to finance his or her retirement needs.
In this case, the government bore some of the first-year loss, and the surviving spouse will probably receive some 28 years of tax-exempt capital gains.
Of course, loss harvesting opportunities are larger when the investor buys individual stocks instead of stock funds. This is especially true in flat or increasing markets, since during those times some individual stocks will still experience losses. But this couple prefers the simplicity of mutual funds.
These tax-efficient investing opportunities are legal and available for anyone who is willing to take advantage of the tax code.
The Final Round
Tax-efficient investing is really all about ensuring that, at the end of the match, an investor can hold on to as much of their earned returns as possible.
In this article, we established a second principle of tax-efficient investing, which applies to taxable accounts. In general, for taxable accounts, you should:
Since stocks are more volatile and most of their returns are in the form of capital gains, the tax code naturally favors holding stocks and other assets with substantial capital gains potential in taxable accounts.
In my November article, I will explain other features of todays tax code that also favor holding stocks in taxable accounts and bonds in retirement accounts.
|FEBRUARY COLUMN CORRECTION|
|William Reicheinsteins article Tax-Efficient Investing and What It Means to Your Portfolio, which appeared in the February 2005 issue of the AAII Journal contained an error in Table 2. In the Ending Wealth column for Rays 401(k), taxes due should have been $300 and the aftertax value should have been $1,700. The articles discussion of the table used the correct values, but incorrect values were printed in the actual table due to an editing error. The corrected table appears in the on-line version of the article at www.aaii.com. The editors apologize for the error.|
William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University, Waco, Texas. He may be reached at Bill_Reichenstein@baylor.edu.