Taxes are an important but often overlooked consideration for investors with taxable portfolios. Taxes should affect the asset-allocation strategy of these portfolios in a variety of ways, and impact the relative attractiveness of different types of investments.
For example, bonds are relatively inefficient investments from a tax perspective, because the investor realizes all gains annually, and these gains are taxed at the investor’s top marginal tax rate, such as 35% for higher income investors (unless, of course, they are municipal bonds). In contrast, stocks can potentially be far more tax efficient. For example, stocks held for more than a year are taxed at long-term capital gains rates, which is 15% for most investors, and all qualified dividends are also taxed at that 15% tax rate.
Investors who have both taxable and tax-free portfolios, such as an IRA or 401(k), can optimize the tax efficiency of their total portfolio by thinking about asset allocation across all of their accounts. An investor who holds a diversified portfolio can keep the same overall investment exposures while limiting tax liability by sheltering bonds in the tax-free account and investing primarily in stocks in the taxable account.
A simple example is to assume two $100,000 portfolios, one taxable and one tax-free. Currently, assume both have the same asset allocation: 60% stocks and 40% bonds. This investor may benefit from changing the asset allocation of the tax-free account to 80% bonds and 20% stocks, with the taxable account comprising all stocks.
Within each asset class, there are varying levels of tax efficiency. Generally index investments are very tax efficient, while actively managed funds can vary significantly in their level of tax efficiency. By not holding securities for more than a year, some mutual-fund portfolio managers subject the shareholders to unnecessary taxes. One way to gauge the tax efficiency of a mutual fund is to use metrics like the Morningstar Tax Cost Ratio. <p/>