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Increase Your Returns by Focusing on Taxes
Too often, investors spend all their time focusing on their gross investment returns and ignore the tax efficiency of their investments. If you reduce the taxes paid on your investments by even a small amount it can have a big impact on your net, after-tax return.
An example will help illustrate what we’re talking about. Suppose your taxable investment accounts amount to $100,000, currently, and earn 7% annually, on average, over the next thirty years. Let’s assume your after tax return is 6%. Let’s further assume that through prudent placement of income-producing assets and selection of tax-efficient investment vehicles that you can increase your after-tax return to 6.5%. At a net return of 6% after tax, your $100,000 would grow to $574,349 after 30 years. With an improved 6.5% after-tax return, your $100,000 would grow to $661,436, a difference of $87,087!
Clearly, it pays to spend some time focusing on the tax efficiency of your portfolio. How do you do this, you ask? First, you need to pay attention to the assets you place in your taxable accounts versus the assets you place in your retirement accounts. IRAs and 401(k) accounts grow tax free. Therefore, it makes sense to place income-producing assets (i.e., those that pay interest and dividends) in your retirement accounts and place assets that don’t generate much income, such as non-dividend-paying stocks and growth funds, in your taxable accounts.
When selecting mutual funds, it also helps to pay attention to their tax efficiency. On the Morningstar® website, you can click on the “Tax” tab for mutual funds to see the pre-tax return, tax-adjusted return and tax-cost ratio for mutual funds. Morningstar also provides the Potential Capital Gains Exposure (PCGE) of a fund. Potential capital gain exposure (PCGE) is an estimate of the percent of a fund’s assets that represent gains. PCGE measures how much the fund’s assets have appreciated, and it can be an indicator of possible future capital gain distributions.
Selecting good investments is more involved than many people realize. Focusing on the tax characteristics of your investments can have a big impact on how much your portfolio grows.
An example will help illustrate what we’re talking about. Suppose your taxable investment accounts amount to $100,000, currently, and earn 7% annually, on average, over the next thirty years. Let’s assume your after tax return is 6%. Let’s further assume that through prudent placement of income-producing assets and selection of tax-efficient investment vehicles that you can increase your after-tax return to 6.5%. At a net return of 6% after tax, your $100,000 would grow to $574,349 after 30 years. With an improved 6.5% after-tax return, your $100,000 would grow to $661,436, a difference of $87,087!
Clearly, it pays to spend some time focusing on the tax efficiency of your portfolio. How do you do this, you ask? First, you need to pay attention to the assets you place in your taxable accounts versus the assets you place in your retirement accounts. IRAs and 401(k) accounts grow tax free. Therefore, it makes sense to place income-producing assets (i.e., those that pay interest and dividends) in your retirement accounts and place assets that don’t generate much income, such as non-dividend-paying stocks and growth funds, in your taxable accounts.
When selecting mutual funds, it also helps to pay attention to their tax efficiency. On the Morningstar® website, you can click on the “Tax” tab for mutual funds to see the pre-tax return, tax-adjusted return and tax-cost ratio for mutual funds. Morningstar also provides the Potential Capital Gains Exposure (PCGE) of a fund. Potential capital gain exposure (PCGE) is an estimate of the percent of a fund’s assets that represent gains. PCGE measures how much the fund’s assets have appreciated, and it can be an indicator of possible future capital gain distributions.
Selecting good investments is more involved than many people realize. Focusing on the tax characteristics of your investments can have a big impact on how much your portfolio grows.
posted by David C. Patterson and Erin Preston at
10:00 PM
1 Comments:
I agree!
Sometimes the tax far outweighs the earnings so why bother?!
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