Tax Planning

Experts highlight the tax issues every financial adviser should know

Time to remind clients about taxes

No matter what tax reform Congress enacts, funds will still feel a bite

Jul 20, 2017 @ 3:44 pm

By John Waggoner

As Congress turns its attention to taxes, it might be a good time to turn your clients' attention to the amount Uncle Sam takes from investment returns.

The IRS levies taxes on dividends and capital gains distributions in taxable accounts, as well as on the capital gains themselves when your client sells. For the moment, the maximum tax on long-term capital gains (applied to assets held for longer than one year) is 20%. This rate applies to single taxpayers with annual taxable income of $415,051 or more, and married/filing jointly taxpayers with income of $466,951 or more.

Short-term capital gains (on assets held for less than 12 months) and dividends are taxed at the investor's ordinary tax rate – currently topping out at 39.6%. Assuming that maximum rate, the tax bite on the nation's largest stock fund, the Vanguard Total Stock Market Index fund (VTSMX) has reduced its total return from 14.4% annually to 11.3% in the past five years, according to Morningstar.

The Vanguard fund, like most index funds, is relatively tax-efficient. Stock funds that aim to maximize dividend income are less so. Oppenheimer Rising Dividends (OARDX), for example, has gained an average 11.0% the past five years. After ongoing taxes and liquidation, however, that return shrunk to 7.1% a year, according to Morningstar. (Morningstar's calculation also takes into account the effect of sales charges, or loads.)

Not surprisingly, the tax whack is more dramatic with taxable bonds. The total return from Vanguard Long-term Corporate Bond Index (VLCIX), for example, falls to an annualized 3.5% at liquidation after five years, from 5.7% before taxes. Real estate investment trust dividends are taxed at an investor's ordinary tax rate, too. The Vanguard REIT ETF, for example, has gained 9.3% a year in the past five years, but its post-liquidation return drops to 6.56% after taxes.

Index funds tend to pay less in ongoing capital gains distributions than their actively managed cousins, although there are exceptions. Miller Value Funds' Miller Opportunity Trust (LMOPX), for example, is a highly tax-efficient fund. Its post-tax rate of retur, pre-liquidation -- a gain of 20.5% a year -- was the same as its total return before taxes.

And with some types of assets, taxes on liquidation can be higher than the taxes on long-term capital gains. Funds that invest in physical precious metals, for example, are taxed at a 28% rate. So are collectibles, such as stamps, coins and 19th-century garden gnomes. Of course, during the past five years, being taxed on profits hasn't been an issue for gold investors, at least: SPDR Gold Shares (GLD), the largest physical gold fund, has seen its share price drop 5.3% annually.

Top-performing stock funds in the past five years, before and after taxes
FundTickerMorningstar CategoryPost-tax return (after liquidation)Post-tax return (pre-liquidation)Total return (before taxes)
Miller Opportunity CLMOPXMid-Cap Blend16.8%20.5%20.5%
PRIMECAP Odyssey Aggressive GrowthPOAGXMid-Cap Growth16.2%18.9%20.1%
Vanguard Capital Opportunity InvVHCOXLarge Growth15.9%18.6%19.8%
Fidelity® OTCFOCPXLarge Growth15.4%17.8%20.2%
Edgewood Growth InstlEGFIXLarge Growth15.3%18.3%19.0%
Towle Deep ValueTDVFXSmall Value15.1%18.1%18.8%
Parnassus Endeavor InvestorPARWXLarge Growth15.1%17.3%19.1%
Oberweis Micro-CapOBMCXSmall Growth15.1%18.0%18.7%
Vanguard PRIMECAP InvVPMCXLarge Growth14.6%17.0%18.5%
Hood River Small-Cap Growth InstlHRSMXSmall Growth14.5%17.6%17.9%
Federated MDT Small Cap Core InstlQISCXSmall Blend14.5%17.2%18.6%
Virtus KAR Small-Cap Growth IPXSGXSmall Growth14.5%17.1%18.1%
Loomis Sayles Growth YLSGRXLarge Growth14.4%17.6%17.9%
Morgan Stanley Inst Growth IMSEQXLarge Growth14.3%16.5%18.2%
Shelton Nasdaq-100 Index DirectNASDXLarge Growth14.2%17.3%17.7%
Vanguard Total Stock Market IndexVTSMXLarge blen11.3%13.7%14.4%
Source: Morningstar
Dividends, gains reinvested through June 30.


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