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Thinking About Taxes as Fees Thumbnail

Thinking About Taxes as Fees

Investors are often concerned about fees – and for good reason! Depending on their size and scope, fees can have a large impact in investment returns, especially over a long period of time. I have conversations with clients all the time about fees. Advisory fees, management fees, expense ratios, inactivity fees -- the list can go on.

I recently read an interesting article in the Investments & Wealth Monitor by David Gordon called “The After-Tax Advisor” about another fee that often gets overlooked: taxes. The article argues, and I agree, that we should change our mindset and start to think about taxes on investments as a variable, sometimes unnecessary, fee. Even an extremely high mutual fund expense ratio of 2.5% pales in comparison to a federal tax rate of up to 37%.

If municipal bonds, most of which are tax-free, provided a quality rate of return right now, this would be a brief discussion. Most people’s goals, though, cannot be reached at the current return of 2%, even if it is tax-free. What, then, can be done to reduce or eliminate the tax fee? The answer lies in two areas, asset selection and asset location.

Asset Selection: Based on their construction, some assets are more tax efficient than others. Exchange Traded Funds (ETFs), for example, were created and structured to eliminate, or at the very least drastically reduce, internal capital gains. Mutual funds can generate large internal gains, based on portfolio turnover or redemptions by other holders, which must be passed along to investors annually. ETFs, based on how they’re built, rarely have internal capital gains that flow through to shareholders.

Asset Location: Frequently, investors will have several different types of accounts. They may have a taxable account (like a trust or joint account), a traditional IRA (often from rolling over an old employer sponsored retirement plan), and a Roth IRA. The taxable account, as the name implies, is the least tax efficient way to hold investments. Every dollar of return in a taxable account flows through to a tax form as either income or a capital gain. A traditional IRA is tax deferred, but funds removed from the account are taxed as ordinary income. A Roth IRA is the best account type for tax efficiency as activity within the account is not taxed and, if the account holder waits until after age 59 ½, money pulled from a Roth IRA is tax-free.

Combining asset selection and location together can have a powerful impact. Purchasing the most tax-efficient investments in a taxable account and the least in a tax-deferred or tax-free account can provide a significant reduction in the tax fee. By changing the question “Should I purchase this investment?” to “Should I purchase this investment in this type of account?”, taxes no longer have to be a highly punitive investment fee.

Photo by StellrWeb on Unsplash