What would you say if I told you that you can increase your long-term investment portfolio returns without increasing the risk or even changing which investments you use? You would probably call me crazy or a liar. The fact is, it is relatively easy to do. It has to do with being tax efficient and lowering the tax bill those investments generate.
Many people have investments in various accounts like 401(k), IRA, Roth, annuities, and brokerage accounts. Each of these account types have their own unique taxing structure. By matching up investments by tax efficiency, you can lower the tax bill which keeps more money invested to compound and grow.
Corporate Bonds vs. Growth Stock Mutual Fund
Let us look at a corporate bond. This particular bond earns an annual coupon of 7%. That 7% is taxed entirely at ordinary income tax rates. That rate is whatever the marginal tax rate at the time. For this example we will use someone in the highest current tax bracket (35%) but this is applicable to all tax brackets.
The growth stock mutual fund pays a relatively low dividend (which are mostly qualified) and occasionally sell stocks which have (hopefully) grown in value. When the sales of stock are recorded and the dividends are paid, the tax rate for most people will be 15%. So if the mutual fund has a long-term overall gain of 10%, 1% may come from dividends and the rest from capital gains. If the fund buys and sells about 30% of their stocks every year and most are long-term capital gains, then about 3% of the annual 10% long-term gain would be taxed annually.
So let us look at an example:
$10,000 investment in a corporate bond earns 7% or $700. The total tax bill would be $245 (35% x $700). After tax, the new value would be worth $10,455.
$10,000 investment in the growth stock mutual fund earns 10% or $1,000 for the year. $100 (1%) of the return is qualified dividends and $300 (3%) is long-term capital gains. At the 15% long-term capital gains and qualified dividend rate the total tax bill would be $60 ($400 x 15%). After tax, the new value would be $10,940.
This example illustrates the tax treatment in a brokerage account. If this person had both of these investments in an IRA, the growth stock mutual fund and bond would have no tax due and be worth $11,000 and $10,700 respectively. People often though have multiple account types. If they put the growth stock mutual fund in their brokerage and the bond in their IRA the total tax bill would be $60 because the tax inefficient bonds would not be taxed currently and the tax efficient growth stock would have minimal current taxation. By splitting the investments between a brokerage and IRA, the combined value would be $21,640 vs. $21,395 if it was all brokerage. No difference in investments, just lower taxes.
Another tax issue to consider is when the growth stock mutual fund is sold, it could have lots of long-term capital gains built into it. At that point the tax would be at 15%, if the gain was in the IRA, it would be taxed at ordinary income tax rates when it comes out to be spent. So it is possible to get better long-term tax treatment for growth assets outside a traditional IRA structure than in it. This is not always the case because tax is only paid on distribution from the IRA, if it stays in long enough, the compound interest can out way the benefits of long-term capital gains treatment.
The bottom line is that understanding the tax characteristics of your investments and matching those up efficiently with your available investment accounts can mean real tangible tax savings. Long-term if you can add .25% – .50% in additional return without adding risk by executing this strategy. Over many years the savings add up.