5 Tax Shelters: Measuring the Payoff

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Somebody’s got a scheme to legally delay taxes on your investment or, better still, to eliminate them. How good is that? It pays to know.

You might be on the fence about boosting your 401(k) contribution or contemplating a 529 college savings plan. You might be tempted by a master limited partnership or–God forbid–a tax-deferred annuity. You might have read about a tax maneuver in Forbes.

Tax avoidance is worth real money but sometimes less than you imagine. It might not be enough to cover the fees on a tax shelter or your loss of liquidity. Below, we appraise five ways to defer or erase a tax bill. In these illustrations we assume the taxpayer is in the 42% bracket for interest and salary and 22% for capital gains and dividends. (Those numbers would be about right for a rich Texan or a prosperous resident of a state with an income tax.) Other inputs: Stocks yield 2% and appreciate at a 5% rate; bonds yield 3.6%; blended accounts start out 60% in stocks and 40% in bonds and are not rebalanced.

THE 401(K)

The retirement account gives you a mere postponement of tax, not an exemption from it. On the other hand it allows you to defer tax on your salary, too. Curious mathematical fact: For someone whose tax rate stays constant, a deferral of tax on both the salary and the investment earnings is equivalent to immediate tax on the salary followed by an exemption from tax on investing.

Let’s walk through the numbers. With our assumptions, passing up the 401(k) opportunity makes $10,000 of pay immediately taxable, leaving you with $5,800 to invest. If you invest it in a 60/40 stock-bond blend, that sum turns into $14,500 at age 70, assuming that you don’t rebalance and you don’t sell your stocks until the end. We’re also assuming you use cheap funds.

Using the 401(k) lets you invest the whole $10,000, which turns into a $31,400 IRA at age 70. Now you take the money out, paying income tax at 42%. Note that IRA withdrawals are taxed at full ordinary income rates. (The low rates on stocks are lost inside a retirement account.)

Even so, you wind up with $18,200 after taxes from the retirement account. That’s exactly how much you would have had putting $5,800 away in a tax-exempt account for 20 years.

In this case the tax dodge adds 1.2 percentage points to your annual return, boosting it from 4.7% to 5.9%. If your tax rate goes down in retirement your gain from the account will be even better than 1.2 points.

THE 529

College savings plans don’t just defer the tax on investing, they eliminate it. This kind of tax-favored saving is likely to be a real winner.

Suppose you have an extra $10,000 sitting around when your child is born and want to invest in our 60/40 stock-bond blend.

If you put the money in a Section 529 account for 20 years it will grow to $31,400. That’s all yours to spend on the kid’s junior year. In a taxable account you’d have only $24,900, and that’s assuming you have the wisdom to leave the appreciating shares of stock untouched until you cash out in 2035.

Exemption adds 1.2 percentage points to your annual return: You’d get 5.9% on the tax-free account but only 4.7% after taxes on the taxable account. These are the same numbers you saw in the 401(k) example.

Our figures don’t allow for expenses inside the 529 account, which you will presumably minimize by using a bargain plan such as New York’s. Nor do they allow for the state tax break you get in some states for funding the account. For New Yorkers this cherry on the ice cream could more than pay for the account fees.

Given the tax exemption, why do we rate college savings below retirement savings? Because, if your child applies for financial aid, that 529 account will be subject to a partial grab by the college bursar. Retirement accounts are usually ignored in the aid formulas.


Tax-exempt bonds have lower yields but better tax treatment than other bonds. Is this a good deal?

Because munis have both call risk (good bonds can get snatched away by the issuer) and default risk (Detroit, Puerto Rico), you can’t compare them with bonds backed by the federal government. Better to stack them up against corporate debt.

The Vanguard Intermediate-Term Corporate Bond ETF (VCIT) has a duration, or measure of interest rate risk, of 6.4 years. It yields 3.5% after a modest expense burden. That’s a bit more than 2% after taxes for our hypothetical high-bracket investor.

At the Vanguard Long-Term Tax-Exempt Fund (VWLUX) the duration is the same and the yield is 2.4%. Most states would tax most or all of the payouts from the tax-exempt fund. So let’s shave a bit off its yield, bringing it to 2.3%. That’s a quarter of a point better than the aftertax yield on the corporate fund. So munis are good but not to die for.


Master limited partnerships, most of which are in the business of schlepping energy via pipeline and barge, tend to pay out fat dividends. Examples: Enterprise Products Partners (EPD), Sunoco Logistics Partners (SXL). At least in the early years of your ownership most of that payout is likely to be an untaxed “return of capital.”

But when you sell, you get hit by a tax boomerang. Some of your sale proceeds, potentially the full amount of your previously untaxed dividends, will be considered ordinary income. To that extent the MLP has not shrunk your tax bill. It has only deferred the day of reckoning.

MLP accounting is tricky, since it hangs on when you got in and how much new business the MLP takes on. But let’s create a simplified case in order to zero in on the value of pure tax deferral.

You put in $10,000, we’ll suppose, and get a 6% dividend, not currently taxable. The dividend and share price don’t budge for a decade. At that point you sell. The IRS comes after you for tax, at ordinary rates, on $6,000. You pay the same $2,520 tax on your dividends as if they had been taxed at ordinary rates all along. But you have the luxury of paying later.

If the payouts had been taxed immediately, you’d be clearing $350 a year, for a 3.5% aftertax annual return. The deferral kicks that number up, but only to 3.9%.

Of course, you could do a lot better–if your MLP delivers growth. Also, if you can hang on to the shares your heirs will do well: They can duck the boomerang with the “step-up in basis” conferred on inherited assets. But don’t get carried away by the tax sheltering that MLPs promise. If the company displays meager growth and if estate planning is not part of your thinking, the MLP is not the terrific buy you may think it is. 


Sell your losers and stay out for 31 days, then get back in. Harvest the deduction. What’s this strategy worth? A lot, but not nearly as much as some proponents claim.

Forbes can be counted as a booster of loss harvesting; these pages have promoted the strategy for at least 35 years. It works best when you can get in and out at no cost (with no-load funds) or at low cost (with stock trades at a discount broker). It pays, but not as well, when you run up management fees to have the work done for you.

Aperio and Parametric have been helping wealthy investors harvest losses for years. In 2011 Fidelity took semiautomated harvesting to the masses (fee: an incremental 0.3% a year for customers already paying for other investment management). More recently the robotic money managers Wealthfront and Betterment (both on the Forbes Fintech 50 list) have joined the ranks of harvest hustlers.

The robo-advisors offer bargain rates for portfolio management (0.15% to 0.35% a year). But be wary of the hyperbole.

A Betterment chart highlights a 1.9% potential annual benefit from the strategy over the period 2000-13. Wealthfront cites a possible 2% annual payout. Both vendors duly caveat their claims with discussions of why your results may differ.

The problem: To justify the big expectations you have to assume, rashly, that you can use any resulting short-term capital losses to offset high-taxed income.

You get that high-bracket offset against up to $3,000 a year of ordinary income. Nice, but that’s a meager sum for a wealthy investor. You also get to use harvested short-term losses in unlimited amounts against short-term gains popping up in other accounts. But why would you have those? Tax-wise investors don’t sell, impulsively, for a short-term gain.

Consider this possibility: Losses harvested from your securities will be put to use primarily to offset low-taxed long-term gains. If that’s the case, their boost to your net worth will be on the modest end of the advertised ranges.

Rational investors do often have long-term gains thrust upon them. These gains may arise from a mutual fund, from a home sale that is not fully protected by the $500,000 (per couple) exclusion or from a winning stock position swept away in an all-cash takeover.

Conclusion: You should harvest losses if you can do that with low transaction costs. You can expect to use most of them because they can be carried forward indefinitely. But you shouldn’t count on getting anything like two points of incremental return.

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