Focusing on investment taxes all year — not just in April — can make a material difference in successful after-tax outcomes.
In my discussions with both advisers and investors, I often see confusion about how to calculate after-tax returns — or worse, no consideration of the tax impact on investors. If you aren't considering after-tax returns, how can you define successful outcomes?
Most U.S. equity investors saw negative returns last year, yet 86% of U.S. equity mutual funds experienced taxable distributions (based on a broad look across all products within the Morningstar U.S. equity universes).
To properly calculate clients' after-tax return, an adviser needs to consider the distributions coming from the underlying investments. For simplicity, we'll limit this discussion to mutual funds, individual stocks and bonds.
Identify the distribution
The after-tax return should focus on the actual distribution and/or the realized gain for that year — not the rate of return.
Consider this scenario: If the investment return reflects price appreciation or depreciation in the underlying security without an actual distribution or realized gain, this unrealized gain or loss does not owe any taxes. Deferring this recognition can have a powerful compounding effect over time. So be sure to identify the amount of the distribution first.
Or, if the investment had a negative return and a capital gain or dividend distribution, this distribution likely only made the negative return worse.
Mutual funds can do some of the work
The Securities and Exchange Commission requires all fund companies to publish after-tax returns for their funds. We publish that information daily for many of our '40 Act funds on RussellInvestments.com. You can also use a third-party vendor like Morningstar for after-tax return calculations. Both companies use the methodology that the SEC mandates, which takes the most conservative position by assuming the highest marginal rate applied to the fund's distributions.
This works if your client is in the top tax bracket. (For example: taxable income greater than $612,350 for short-term gains and taxable income greater than $488,850 for long-term capital gains if the filing status is married filing jointly in 2019.) But there is no accommodation for state income tax, which is an additional tax drag and can be meaningful for those in the higher tax states.
If your client is in the top bracket and invests only in mutual funds, you have a head start on trying to calculate the after-tax return of the total portfolio. And that's what really matters for taxable investments.
Do the prep
Identifying the following numbers, among others, can be a beneficial step in preparing to calculate a client's after-tax return:
• What is the amount of your client's actual distribution during the calendar year?
• Where are the distribution amounts located?
• What is the character of the distribution? Was it interest income? Qualified or nonqualified dividends? Long-term capital gains (LTCG) or short-term (STCG)?
• What is your client's specific tax rate? Be sure to consider:
• Marginal federal and state tax rates (the tax on the next dollar earned) for gains taxed as ordinary income to include STCGs, interest income and nonqualified dividends.
• Medicare tax. The 3.8% Medicare tax for the Affordable Care Act remains. This is tied to investment income (interest, dividends and capital gain distributions) for clients with modified adjusted gross income high enough to cross the threshold. This remains at $250,000 for married filing jointly status and is not indexed for inflation (meaning more people will get to pay this tax going forward).
• Does the client have capital losses outside the portfolio you managed, or a capital loss carry-forward to offset distributed gains? If so, it might be possible to use these to offset the current distribution.
Do the math
With this prep work, it's a straightforward calculation to determine the after-tax return as follows:
• Apply the correct tax rate to the calendar year distribution. Use the top marginal rate for STCG, taxable interest, nonqualified dividends or other items treated as ordinary income. Use the LTCG rate for qualified dividends and capital gains held longer than one year. Remember that it's not just the capital gain distributions, but also the taxes tied to dividends. And taxes apply even if distributions are reinvested.
• Do the calculation:
(beginning market value)
The result approximates the client's after-tax return.
It may help to look at an example. Here's the math for a hypothetical fund that depreciated in line with the U.S. equity market in 2018. In this case, gains and dividends are treated as long term and taxed as long-term capital gains.
|Top federal tax rate for long-term capital gains||20.0%|
|Medicare tax on unearned income||3.8%|
|Assumed beginning market value||$100|
|Market return||-5.2%||2018 U.S. equity return|
|Fund ending market value||$94.80|
|Assume fund had 12% cap gain distribution||12%||Average 2018 distribution|
|Taxable distribution (amount on 1099)||$11.38|
|Assume fund had 2% dividend yield||2%||Yield in line with broad U.S. equities|
|Taxable dividend (amount on 1099)||$2.00|
|Total taxable distributions (cap gain dist + dividends)||$13.38|
|Assume taxable distribution taxed at 23.8%||23.8%|
|Federal Tax Due||$2.71||Tax due - even with negative return|
|Ending market value (Net of tax paid)||$92.09|
Not only was the hypothetical fund down for the year, but when you consider taxes, it was down 2.7% more than the reported pre-tax return. (The ending market value in this equation assumes distribution was reinvested.)
Calculating after-tax returns for your clients can help you determine whether there are opportunities to help maximize your clients' after-tax wealth.
This is powerful information to share in client reviews, especially with higher-net-worth investors. And who couldn't use a few more of those as clients? Remind your clients it's not what they make, it's what they get to keep!
Frank Pape is senior director of the North America portfolio consulting group at Russell Investments.