What might tax liability mean to you?

Let’s face it – nobody really likes paying taxes, especially investors. We all know investment returns can be taxable, but most investors generally hope to minimize taxes so they can try to maximize net returns. And why not? Reducing taxes on an investment portfolio can help to increase an investor’s after-tax wealth. But the overarching goal should be about maximizing after-tax wealth - not tax avodiance. Avoiding a tax is not a financial plan. Understanding the impact of taxes on client portfolios 43.8% Tax rate: Top marginal rate of 39.6% + 3.8% Net Investment Income Tax, ** LT Cap Gain rate of 20% + 3.8%% Net Investment Income Tax. This example does not reflect the deduction of state income taxes. If it had, returns would have been lower.
This is a hypothetical illustration and not meant to represent an actual investment strategy.
Taxes may be due at some point in the future and tax rates may be different when they are. Here’s a hypothetical example that shows the potential impact of taxes on an investment portfolio. Our prudent investor, we’ll call him James, has a $1 million nest egg. Over the next 10 years he has three options for investing that money. One strategy is fully tax-managed and successfully defers all gain recognition to a later date. The second treats all gains as long-term gains for the funds, but in doing so incurs taxes of 23.8% (rate for those in the top tax bracket) each year. The third approach chases short-term gains, which results in the annual gain being taxed as short term and treated as ordinary income at 43.4%. As you can see in the chart, the fully tax-managed strategy could potentially help net big gains, more than doubling the initial investment. Going after only long-term gains in this hypothetical situation looks good if taken by itself, but less appealing when matched against the fully tax-managed strategy. And if James chooses to chase short-term gains -- ouch! That approach could potentially yield half the gains of a tax-managed strategy. Yet, it’s understandable that people might choose the initial potential returns of short-term gains because the high activity of buying and selling  can seem appealing. But that is only part of the story  especially when the potential tax consequences are not taken into account. So what could investors do when their goal is not to avoid paying tax, but to help gain higher after-tax wealth? The key may be to locate investment funds in a manner that’s right for their tax status. For instance, an investor might have a stock portfolio that turns over rapidly, maybe 100% or more within a year. Such turnover can create a lot of short-term capital gains, which, as we’ve seen in the above example, also incurs the highest tax. So any portfolio like that might serve an investor’s goals better by being under a more tax-friendly investing umbrella, such as a 401(k). Commodities can be another tax-unfriendly investment vehicle, so they too may serve an investor’s tax-managed investing strategies best by being held in accounts that have a tax- deferred or tax-exempt status. (I’ll write later about portfolio turnover that can be good for reducing taxes through a process called loss harvesting). Just know that there is “good” turnover and “bad” turnover in regards to taxes. Other investments that can be tax-friendly, such as municipal bonds, can go into accounts that have a bigger tax load. Tax-managed mutual funds are another way to help lower the tax burden on investments.

The bottom line

Be aware of the impact of taxes, and start asking questions about how to lower tax burdens. Too many investors – and their advisors – take a “set-it-and-forget-it” approach to investment portfolios. But the consequences of such an approach can also mean unintentionally “setting it and forgetting it” when it comes to taxes. So be tax-smart: Seek investment strategies that are designed to help you see good returns while helping to reducing your investments’ tax burden.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries. Exposure to the commodities markets may subject the investment to greater volatility than investments in traditional securities, particularly if the investments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or sectors affecting a particular industry or commodity and international economic, political and regulatory developments. The use of leveraged commodity-linked derivatives creates an opportunity for increased return, but also creates the possibility for a greater loss. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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