Tax rates have risen for some investors with six-figure earnings, simultaneously lifting the importance of tax-smart investing.
Income funds are of particular concern because they tend to distribute ordinary income, the most tax-costly form of investment earnings. Re-evaluating these funds’ tax-efficiency in view of the changes is probably a worthwhile exercise for advisors who use income funds in taxable client accounts. Unfortunately, the analysis is not a perfect science.
“A lot of assumptions go into it,” says Jack Chee, an analyst at Litman Gregory Asset Management. The Orinda, Calif.-based money management firm recently rank-ordered the nine income funds it uses in client portfolios according to tax-efficiency under the latest rates.
Although other practitioners might use different assumptions, the firm’s analysis illustrates one approach to consider when comparing after-tax returns between funds or investments.
Begin by choosing marginal tax rates for both ordinary income and long-term capital gains. Litman Gregory assumed a whopping 52.6 percent rate on ordinary income, which includes 8 percent for state income tax. The federal portion consists of this year’s top ordinary rate of 39.6 percent (applicable when joint income exceeds $450,000, or $400,000 if single), plus 1.2 percent due to the phase-out of itemized deductions (hitting joint filers above $300,000, singles above $250,000), plus the 3.8 percent Medicare investment-income surtax (on joint incomes topping $250,000, or $200,000 if single).
The personal-exemption phase-out was ignored. Including it could potentially add a few more percentage points to an investor’s tax rate, depending on the number of exemptions claimed.
For long-term capital gains and qualified dividends, the firm substituted 20 percent for the 39.6 percent ordinary rate, yielding a combined federal and state rate of 33 percent.
The next step is projecting future distributions to apply the tax rates to. Litman Gregory looked at the proportions of each fund’s historical distributions that came from ordinary income, short-term gains, long-term gains and qualified dividends.
“You also have to factor in current valuations in the bond market,” says Chee, which he presently believes are high. “We made the assumption that you’ll get very little return from capital appreciation until bond prices decline. Almost all of the return will come from income.”
Defaults, or the likelihood of not receiving distributions, are another consideration. Litman Gregory thinks defaults across most fixed-income asset classes will remain below historical averages -- about 2 percent in the high-yield bond and floating-rate loan markets, or roughly half of the long-term average. “Companies have a lot of cash on their balance sheets to meet the relatively small amount of maturities occurring in the next few years,” Chee says.
A qualitative factor to account for is the fund manager’s approach. Is tax-efficiency a priority? More so for some managers than others, according to Chee.
Combining these and other variables, Litman Gregory concluded that FPA New Income was the most tax-efficient of the nine income funds in its client portfolios. Very conservative, FPA New Income has among the smallest distributions of the funds studied, which in turn produces a small tax cost.
Pimco Unconstrained Fund, an absolute-return-oriented fund, was also determined to be relatively tax-efficient. It can be used to protect a fixed-income portfolio’s value against rising interest rates, Chee says. “This fund can have zero duration, or it can even go negative through derivatives, which means the investor could actually benefit from rising interest rates.”
At the other end of the spectrum, the least efficient fund on the firm’s approved list, is Osterweis Strategic Income, a high-yield short-term bond fund, followed by Pimco Emerging Local Bond.
From an asset-location standpoint, tax-deferred accounts are the optimal place to hold such investments. But tax considerations are only one factor in investing, and Litman Gregory salts relatively tax-inefficient funds into clients’ taxable accounts (which are predominated by municipal bonds).
“Osterweis Strategic Income has an after-tax return that is competitive with munis, while its short duration enables us to tactically shorten aggregate portfolio duration to help protect against rising interest rates,” Chee says.
Meanwhile, Pimco Emerging Local Bond is a foreign-currency bond fund that provides protection from a collapse in the dollar and likewise offers potentially attractive after-tax returns.
Funds on Litman Gregory’s short list lying in the middle of the tax-efficient spectrum are Loomis Sayles Bond, DoubleLine Total Return Bond Fund and DWS Floating Rate Plus.
Litman Gregory shared the results of its analysis with clients in its March investment commentary.