With tax season over, now is a great time for financial advisers to take a look at their clients' returns and reflect on opportunities to be even more tax efficient next year.
Though one should not let tax considerations dictate an investment strategy, advisers and investors should still be reviewing whether there are more tax efficient ways to invest. In an endless search for the elusive “alpha,” timing and stock selection can sometimes take priority. Though there is a time and place for this focus, other areas of an investor's portfolio can generate immediate relative returns with significantly less risk and effort.
When executing a plan that takes advantage of these opportunities, one generates a different type of alpha called “tax alpha.” Here are some of the most common areas that often go overlooked:
1. Master limited partnerships: The potential tax advantages of MLPs are not new. This has been the primary structure of choice for companies operating in the energy industry (and particularly in the oil and gas transportation and infrastructure sub-segment) to gain access to public capital. In the past, only accredited investors could participate in benefits such as pass-through income (avoiding the double taxation of a traditional corporation), and potential payouts classified as a return of principal rather than a dividend.
In an MLP structure, however, those same benefits are available to any investor with a brokerage account, and typically include daily liquidity and no minimum requirements. Not all MLPs or MLP funds are created equal, however. Advisers and investors should be particularly careful when holding these companies or funds in an IRA. IRAs are subject to a special rule called unrelated business taxable income, which may actually cause clients to pay tax on their IRA for those investments. Additionally, many MLPs issue a K-1 form instead of a 1099, and they have been known to arrive at investors' doorsteps after April 15, requiring an amendment.
2. Fixed income: When it comes to a portfolio full of stocks, bonds are likely the most common diversifier, whether they are held within a fund or with the direct purchase of a company's or municipality's debt. With income tax rates at their highest in years, a high earner in Los Angeles could feasibly pay more of her paycheck to federal and state governments than she actually takes home (39.6% federal, 3.8% Medicare, 20% cap gains, 12.3% California state tax, and 9% sales tax).
Of course, using municipal bonds has the potential for tax-free income at the federal, state and local levels, which may make sense for someone in those higher income brackets. Another misstep is keeping these tax-advantaged bonds in accounts that are already tax-advantaged: traditional and Roth IRAs or the investment accounts of tax-exempt organizations.
3. Investment vehicle: For broader diversification, it is often easier to buy a basket of investments within a mutual fund or, increasingly over the last 10 years, an exchange-traded fund. It is imperative to understand the tax implications of these vehicles. Pay attention to a fund's turnover, which provides clues on the amount of the portfolio that is kept for longer than one year.
Higher turnover funds (sometimes 150%+) are typically tax inefficient as their gains are taxed at the same rate as ordinary income instead of the preferential capital gains rate on investments held for over one year. Actively managed mutual funds typically have significantly higher turnover than passively managed ETFs. Particular attention should be paid to timing in which a mutual fund is purchased. At the end of the calendar year, large distributions (which seem like huge dividends but are actually short/long term capital gains) can cause a fund buyer to pay taxes on gains she didn't see.
4. Cost of living adjustments: The tax man isn't all bad. Certain retirement-related items are indexed to inflation to help investors to save the same amount every year, partially offsetting the effect of inflation. From 2014 to 2015, the IRA and 401(k) contribution limit was increased by $500. This may seem like a small amount, but over time and compounded with investing, it could potentially mean thousands of dollars in retirement. Many retirement savers wait until year-end to make their contributions.
While it's understandable that the intra-year tax picture might be unclear, missing out on a full year's worth of market performance like 2013 and 2014 dulls the effectiveness of these exceptional investment accounts.
Theodore E. Saade is a senior partner and Richard J. Nott III is associate adviser of wealth management at Signature Estate & Investment Advisors.