Does tax managed investing make sense for you?
Most of us are familiar with the famous quote from
Ben Franklin, “The only things certain in life are death
and taxes.” Most investors would also partially agree with
John Maynard Keynes statement, “The avoidance of taxes
is the only intellectual pursuit that carries any reward.”
Should you focus on tax consequences or other objectives?
How concerned are you with the tax consequences of your
investment choices? Should you allow tax considerations to
determine your investment choices, or should you focus on
total return and your overall investment objectives?
Recent studies point to the significant negative impact that
taxes on dividends and capital gain distributions can have
on an investor’s annual returns. T. Rowe Price, one of the
largest mutual fund managers, and Lipper Inc., a global
leader in providing mutual fund data, provide facts and
research that are difficult to dispute, based on the
assumptions. The extent of the negative impact depends
on the investor’s tax bracket, and grows as the mutual fund
passes through more short-term gains.
Beware of making hasty decisions
Although mutual fund studies generally make perfect sense,
don’t use them to make hasty decisions. Tax efficiency fund
ratings and research make a host of assumptions about tax
rates, turnover, and rates of return that may not apply to
you. It is just simply not reasonable to think that a blanket
rule or decision will be true for everyone.
The reliability of mutual fund ratings depends largely on
whether tax rates on income and capital gains will remain
steady in the future or even in the next few years. This is
impossible to predict. The changing political climate in
Washington might dramatically change the capital gains
rate, throwing the best tax-conscious decisions into chaos.
While some candidates propose keeping the 15% capital
gains tax rate, others propose changing it to 20%, 28%,
or even lowering it to 0%.
Use a long-term strategy that takes taxes into account
What makes the most sense is to establish a long-term
strategy that can accomplish your investment objectives,
and make it “tax-smart” by considering your current and
projected income requirements, your time horizon for
investing, and your total return requirements.
To get an optimal investment return, coordinate your efforts
with your tax and investment professionals, make a conscious
effort to control investment expenses, and select investments
and accounts appropriate for your tax situation.
Base your investment selections on their merits as sound
investment choices within your overall asset allocation. In the long run, this will give you much better results than
using some tax efficiency rating based on a long series of
assumptions that may or may not apply to you.
Jesse L. Nelson, MBA, is an investment manager with Schenck Investment
Solutions LLC. In addition to constructing
and managing portfolios for individual clients and 401(k) plan participants, Jesse also researches and analyzes stocks
and mutual funds.
November 2007
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