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October 12th, 2012 | Invest With Reason

Think Tax-Efficient Investing Matters Now? Just Wait…

Imagine this scenario: the top tax rate on ordinary income, including interest income, rises 25%. The highest marginal rate on long-term capital gains spikes by 60%. The top dividend tax rate nearly triples.

Sound far-fetched? Unfortunately, it is not. Between the expiration of the Bush tax cuts and the 3.8% surtax of the Patient Protection and Affordable Care Act (aka ObamaCare), these rates* will become reality in 2013 if Congress does nothing. While we can’t know for certain how this will all play out, I think investors would be wise to proactively review their portfolios to examine whether they are built for higher tax rates—and if they are not, to consider taking some actions now before rates rise.

Tax Bite

I have written before about the vital importance of combining thoughtful tax management with any investment strategy (for example, see my prior post, Learning to Love the 1040. Here is one yardstick. I calculated a popular US stock index fund’s pre- tax and after-tax returns from September 1, 1976 to December 31, 2012 using a 40% tax assumption for income and 20% for capital gains. Keep in mind, investing in index funds is one of the most tax-efficient strategies available for stock investors.

On a pre-tax basis, a buy-and-hold $100,000 investment in the index fund compounded at 10.36% a year, growing to a terminal value of $3.26 million over a period of nearly 36 years. On an after-tax basis, the investment returned 8.88% annualized, resulting in a $2 million value. In other words, income taxes claimed nearly 1.5 percentage points of investment gains per year (not including capital gain taxes, if the investment is sold at the end of the period) and reduced profits by 39%. But with adroit tax management at the portfolio level, an investor can position him or herself to surrender less to the tax man.

Sizing Up a Portfolio

Particularly in light of looming tax increases, it makes sense to see how strategies such as tax-loss harvesting, efficient asset location and tax-rate arbitrage may be applied to portfolios. Tax- loss harvesting is the practice of selling securities at a loss and applying those losses to offset realized taxable capital gains (for more on this strategy, see Tax Tips for the Investor. But if, for instance, you hold a concentrated stock position with an outsized weighting in your portfolio, perhaps it makes sense to harvest some of the gains, pay taxes now at a lower rate, and diversify your equity holdings. Or maybe you can offset some of the tax you pay today by recognizing losses in the portfolio.

In terms of asset location, are your bonds, stocks and dividend-paying assets allocated efficiently on an after-tax basis in your taxable and retirement portfolios? Particularly if your tax rates will be higher in future, it may make sense to engage in some tax-rate arbitrage (pay taxes now, not later) by contributing to Roth IRA and Roth 401K plans, rather than to traditional plans. Big picture, think of it this way: future tax outcomes are unknown (but quite likely rates will be higher). If you hold off paying taxes on retirement contributions or on unrealized capital gains of stocks held in taxable accounts, it introduces another level of risk in your portfolio.


Tax rates quite likely will rise in 2013, and possibly by a substantial amount. Now is a good time for investors to examine their portfolios to see if they are designed for higher taxes and to engage proactively in tax- management strategies.

*Top rates would rise from 35% to 43.4% on ordinary income, form 15% to 23.8% on long-term capital gains and from 15% to 43.4% on dividends.

As Published On: Forbes


Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gerstein Fisher), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  All references to market performance was obtained from Bloomberg database. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Gerstein Fisher.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Gerstein Fisher is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Gerstein Fisher’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

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