Experienced money managers like to say you shouldn't "let the tax tail wag the investment dog," meaning you shouldn't let concerns about the tax effects of an investment drive your buy and sell decisions.
That is probably good advice, but in this post-"fiscal cliff" era of higher income-tax rates and new health care reform-driven investment taxes, it makes sense to at least look at the tax impact of your savings choices.
"A good financial planner should be looking at how tax-efficient your investments are," said David Blanchett, head of retirement research for Morningstar Investment Management. He said the difference between having a $1,000 gain taxed at the long-term capital-gains rate of 20 percent versus the income-tax rate of 35 percent would save the investor $150. And that example doesn't even use the top income-tax rate or note other new provisions could hit investment income as well.
Upper-income households at several levels face higher tax burdens this year. Individuals with adjusted gross incomes of more than $200,000 ($250,000 for joint-filing couples) will face a 2.8 percent Medicare surtax on investment income.
Singles who earn more than $400,000 (joint filers more than $450,000) will face a new top marginal tax bracket of 39.6 percent. Those same people will see their tax rates on dividends and long-term capital gains go up to 20 percent from 15 percent. And limits on itemized deductions and personal exemptions will start to kick in on incomes of more than $250,000.
That all points to at least considering the wagging tail before you buy the dog. In addition to being taxed itself, income from investments could push investors into higher tax brackets, so minimizing taxable income could be an especially good idea for investors on the cusp of higher brackets. And some tax-smart investments actually perform better than their tax-ignoring counterparts.
Take tax-efficient mutual funds. They are actively managed to minimize the taxable income produced.
Lipper analyst Tom Roseen compared the after-tax performance of every major tax-managed mutual fund with the average after-tax performance of its whole category. "Tax-managed funds, on average, did a fine job," he said. For example, over the 10 years ended Dec. 31, the tax-managed large-cap core stock funds returned an annual average of 5.82 percent after taxes. The entire category of hundreds more funds returned 5.71 percent after taxes.
"In only six classifications of 20 did they not outperform their category average, and that is a pretty strong statement," Roseen said.
Will an active manager beat an ETF by enough to justify her fees? Sometimes yes, and sometimes no. That's a question of investment philosophy that chartered financial analysts can spend their entire careers trying to answer, so it's OK to answer for yourself.
That sounds complex, but at Motif Investing Inc (http://www.motifinveseting.com) and Foliofn Investments Inc (http://www.folioinvesting.com) you can buy a fixed portfolio for a low fee. Because investors end up owning fractional shares of individual stocks, there are no capital gains distributed annually, as there would be from a mutual fund. Both sites let you manage the portfolios for maximum tax advantage by selling individual stocks to lock in losses.