Kids love surprises. When I was little, I remember how I felt when my parents told me we were going someplace, but it was “a surprise.” I knew it was something good. They weren’t going to surprise me with a trip to the dentist or a tetanus shot at the doctor. This was a restaurant, a new baseball glove, or an early birthday present.
Things change when you get older. Surprises can mean anything. Good, bad, ugly, or expensive. And at tax time, surprises are almost always a bad thing.
Recently someone told me that they had a super expensive tax bill because of their investments. They actually didn’t have enough money in the bank to pay the bill! But it was OK, they assured me, because it must have meant that their investments “did really well last year.” So many things ran through my head that I had to stop myself from blurting out something I’d regret.
When evaluating investment performance — which is admittedly not an easy thing to do well — one usually looks at the “net” amount they have made over a certain period after all expenses. This means mutual fund expenses, advisory fees, transaction costs, etc., in accounts that are non-qualified (non-IRAs).
One of the most important items to assess is the amount of taxes the account is generating. After all, if an account returns 8% after expenses but creates another 3% in tax come April, the real return is much lower.
Generally speaking, investments create tax liability in non-qualified accounts in one of two ways:
- The investor sells shares at a profit.
- The investment involuntarily produces a distribution that is taxable to the investor.
In terms of investment sales for a profit, a good money manager is aware of their client’s tax situation and takes adverse tax consequences into account before completing a sale.
At the very least, the advisor checks in with the client to let them know the sale is necessary to maintain the stated risk objectives or to capitalize on an opportunity. Unless the client really loves surprises, letting them know to plan for a higher than normal tax bill is more than appropriate.
The best money managers are well-versed in tax-loss harvesting techniques. They know that some gains from profitable positions can be offset by sales of underwater positions by exchanging them for a similar basket of securities, so as not to lock in an actual investment loss in the asset class.
Surprise! Large capital gains distributions are often bad news, not good news.
Many mutual funds are notoriously tax-inefficient investment vehicles. One of the reasons for this notoriety is what happens when an active fund manager discards old (or new) positions that have gained value since the time they were purchased.
By law, those realized gains must be distributed to shareholders. Most funds end their fiscal year in October, announce distributions in November, and make the distributions in December.
So far, so good, right? Unfortunately, when the distribution is paid, the share price of the fund will drop by the amount of the distribution. That means the distribution itself has no impact on the balance of each shareholder’s account. Nevertheless, outside of IRAs, this creates a taxable event for the shareholder.
The worst-case scenario occurs when someone buys a fund during a flat or down year in the market, and at the end of the year, the fund makes a distribution based on realized gains from disposing of positions held for many years.
Those positions had gains, but not for the newer shareholders! Those lucky newbies get the same tax bill as the long-term shareholders. CPAs and financial advisors know no wrath like the client who receives a large tax bill after seeing their investments lose 10% in value for the year. Not a great combo.
The Bottom Line
Tax-efficient investing is a must for non-IRA accounts, especially when balances and tax rates are significant. Some mutual funds should never be held in non-retirement accounts. Nevertheless, many money managers create model portfolios that look the same regardless of what type of account they are assigned to.
ETFs, municipal bond funds, and individual securities should be more prevalent, especially for wealthier investors inside non-tax-sheltered accounts. Here, when it comes to taxes, the stakes are too high to passively manage account holdings. April is when you find out what tax-efficient investing is (or is not) all about.