Tax Missteps Can Cost You 25% of Long-Term Returns—Here Are 3 Important Corrections

Americans pay over $1 trillion in federal income tax. Yet most of us don’t like thinking about taxes. Many investors distance themselves from the topic altogether as it can seem too ‘complicated’, ‘time consuming’, or ‘boring’. Improper tax management can severely limit your spending power in retirement. In fact, it can cost you more than 25 percent of your long-term return. Here are three methods to lower your tax bill.

Method #1

Utilize Retirement Plans. Almost all companies offer some form of tax-advantaged retirement plan. It could be a 401k, a 403b, or a Roth 401k, among others. Individual Retirement Accounts (IRAs) are also available. (For more on the differences, see Can I Contribute To A 401k And An IRA?). While there are different rules surrounding contributions and withdrawals for each plan, a key similarity in all of them is tax-deferred growth. 

This is a major gift to investors, compliments of the US government. Why? The power of compounding. Investments grow unabated from taxes with dividends and income reinvested along the way. This significantly improves long-term return potential and the probability of reaching your most important financial goal: retirement. Moreover, most employers offer some form of matching contribution based on the amount you save into the plan. This is free money and only further improves your chances of success. So if you have the means to save, make sure to take advantage of any available retirement plans. You’d be surprised how many investors don’t. 

Method #2

Use Tax Efficient Vehicles. There are thousands of investment vehicles to choose from, and each can have radically different tax implications. Knowing which are most efficient (and which are inefficient) is a vital first step in reducing your tax bill—it also helps filter your choices to a smaller, more reasonable list.

Mutual Funds are notoriously bad from a tax perspective because high turnover often creates large tax bills. According to Morningstar.com, the ten largest mutual funds by assets had an average turnover ratio of almost 75%. The impact is clear. A 2010 study by Lipper (Taxes in the Mutual Funds Industry – 2010; Assessing the Impact of Taxes on Shareholder Return) showed owners of mutual funds in taxable accounts gave up an average of 0.98 percent to 2.08 percent in annual return to taxes over the last 10 years. This is significant. As seen in the figure below, a difference of 1% over 10 years results in over $17,000 less on a $100,000 portfolio.

The performance for the chart above reflects performance net of fees.

Relative to mutual funds, Exchange traded funds (ETFs) are a step in the right direction. In fact, greater tax efficiency was the primary reason ETFs were created. But the best way to mitigate taxes is to create a portfolio of individual securities, or a combination of individual securities and ETFs—one of the many facets of a strategy we call Smart Indexing. This allows for tax management on multiple levels. 

Method #3

Tax Locate & Tax Loss Harvest. If you have taxable and tax-deferred accounts, you can also tax locate. Tax location involves placing higher yielding securities in tax-deferred accounts to shield their income. Additionally, income from most REITs and bonds does not qualify for the same favorable tax rate as stock dividends. It is advantageous to strategically place these securities in tax-deferred accounts.

With a portfolio of individual stocks and ETFs, there is also a wider set of options to meet cash flow needs. This makes it easier to defer gains into future years, and if you have to sell low basis positions, you can harvest losses from poor performers to mitigate or neutralize the impact. Tax loss harvesting is a method of selling securities that have decreased in value in order to recognize a capital loss. Up to to $3,000 per year of capital losses can be written off against ordinary income with tax loss harvesting.

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Personal Capital can help you see which funds you own in which accounts to root out these tax missteps. It's free, and is part of an award-winning financial tool that Forbes contributor Rob Berger calls "My personal favorite and the tool I use daily." If you work with Personal Capital’s advisors, they can implement Smart Indexing for you, and they have a technology platform that does tax loss harvesting automatically.