As a nation we face many challenges:
• Our federal government spends a lot more than it brings in. The ratio of expenditures-to-receipts is running at an unsustainable level -- careening towards eventual disaster. The federal government deficit is now 7.2 percent of GDP.
• Total outstanding government debt of all types is now 165 percent of GDP. As recently as 1981, this number was a far more modest and responsible 52 percent. These figures include gross federal debt, government-sponsored entity (e.g., Fannie Mae) debt, state debt, and local debt.
• The U.S. net international investment position has reached -27 percent of GDP. In other words, we would have to take 27 percent of our current GDP to pay foreigners back for all the capital we’ve received from them.
• Just two entitlement programs (Social Security and Medicare) currently consume 8.6 percent of GDP. Based on the current structure of these two programs, this figure will increase by +50 percent, rising to 12.8 percent of GDP by 2085 -- a truly unsustainable level.
• The U.S. economy is expected to experience unusually low economic growth for the decade ahead.
• The American public has clearly communicated their unwillingness to cut back on entitlement programs.
Collectively, these factors will have many effects. However, one effect rises far above all others -- taxes are going up and by a lot. We are likely to see, not just a single tax increase, but unfortunately, a series of sequential tax increases. Just as in Spain, Italy, Portugal and Greece, those nations that insist on living beyond their means must eventually pay the piper and radically increase their tax rates.
So, what to do? Let’s try a thought experiment and work through a hypothetical investment scenario with and without active tax management. Here are the assumptions (overly simplified, but they allow for straightforward math):
The Hypothetical Investment:
• 12-year investment period
• Investment earns a constant 10 percent per year, with 8 percent coming from capital gains and 2 percent from interest income
• All capital gains are short-term and realized in the year that they occur
• All interest income is fully taxable
The Hypothetical Investor:
• 43 percent tax rate on interest income
• 43 percent tax rate on short-term capital gains
• 20 percent tax rate on long-term capital gains
Under these assumptions, the pre-tax return is 10.00 percent per annum, but the after-tax return falls to 5.70 percent
Let’s assume we could actively tax manage this account such that the following held true:
• The realization of capital gains are delayed by 3 years (for tax purposes)
• 65 percent of all capital gains are converted to long-term status
• Interest income is converted to municipal tax exempt interest
• But, as a consequence of the use of municipal bonds, the interest rate falls by one-third
The results of such an active tax management program increase the realized after-tax return by over 34 percent, from 5.70 percent to 7.65 percent. The serious question then becomes, are such active tax management benefits (a 34 percent improvement) both reasonable and achievable? I would argue the answer is, absolutely yes. But success will require the active combination of seven synergistic tax management techniques. Let me explain.
Tax minimization relies on three main strategies -- Delay, convert and replace:
DELAY. By delaying the realization of capital gains from a tax standpoint, it allows the investor to hang on to their money longer, gaining the benefit of growth over time. This benefit can be achieved through two techniques.
• First, employ active tax loss harvesting during the last two weeks of December each year.
• Second, make use of commingled trusts with existing embedded capital losses. This second technique is a new one; that is only now practical after some recent changes to the tax law. Previously, commingled vehicles such as mutual funds could only carry forward their embedded capital losses for a very short number of years, at which point any unused embedded losses were lost. But today, under the revised tax statutes, these embedded losses may be carried forward indefinitely.
CONVERT. By converting the recognition of capital gains from short-term to long-term, the investor’s tax bill is meaningfully reduced.
• This benefit can be achieved by adopting a year-and-a-day holding period for all investments. After suggesting this approach, I sometimes hear the question, “But if I hold my individual positions for a year-and-a-day, then don’t I have a passive investment instead of an active investment -- in effect forcing me to give up the benefits of active management?” Such a conclusion is obviously false. It confuses a rather important attribute of active management. The size of an active management bet is based on how far the portfolio has been positioned away from the passive benchmark -- and NOT on how frequently one changes their mind about what the bet should actually be (i.e., how frequently one trades).
REPLACE. By replacing taxable bonds with municipal bonds and replacing high dividend-paying stocks with low- or non-dividend paying stocks, the investor’s tax bill is once again reduced. Three techniques may be beneficial.
• First, use municipal bonds instead of taxable bonds.
• Second, when interest rates are at an appropriate level, obtain a greater portion of the risk mitigation properties of a portfolio from municipal bonds instead of other taxable asset categories.
• Third, substitute low- and non-dividend paying stocks for high-yielding equities.
Through the consistent and fully integrated use of these seven active tax management techniques, it is quite reasonable to expect the type of benefit identified above in the hypothetical example - improving the after-tax return by a third for those in the highest possible marginal tax brackets. The taxman is coming; it is best to be prepared.
(All data for this article was provided by Ned Davis Research Inc., Atlanta, Ga., and is current as of 11/28/2012.)
Rob Brown, Ph.D., CFA, is the chief financial strategist for Eqis Capital Management Inc. You can reach him at [email protected].