I was recently a guest on the Morning Shift on Chicago Public Radio about retirement planning.
Here are some simple tips to create a more tax efficient portfolio:
Invest in Index Funds
Index funds generate lower short-term capital gains and higher long-term capital gains due to much less frequent buying and selling. Short-term gains are taxed every year as ordinary income. Long-term gains are taxed at lower capital gains rates, and most are only realized when you sell your shares.
The idea here is to place assets that produce higher income (e.g. bonds) in tax advantaged investments (IRA, 401k) that will allow you to not to have to pay taxes annually on the income.
Then putting assets that generally produce less income (e.g. stocks) in taxable accounts. You will have lower taxes each year, and when you sell your shares you will pay the lower long-term capital gains rate on your profits.
What about Roth IRAs and Roth 401k Accounts?
Since any gains in these accounts are tax free when withdrawn, it does make sense to put assets that will have the highest long-term growth in these accounts as well (e.g. stocks) as an exception to the rule above.
It will often not be possible to execute this perfectly with all of your income producing assets neatly tucked away in your Traditional IRA and your growth assets in your Roth IRA and taxable accounts.
Also please do not let the desire for tax efficiency overwhelm having the right asset allocation for your long-term needs. Tax efficiency is really a tactic not a strategy.
There are two basic types of mutual funds:
Actively Managed Mutual Fund
In this type of mutual fund the fund manager attempts to pick investments which he or she feels will outperform the overall market. Typically this type of fund does a lot of buying and selling of individual investments, turning over its portfolio about three times per year. The average charge for a actively managed stock mutual fund is about 1.35%. This means that every year the investors in the fund are charged about $13.50 per $1,000 invested.
Passive (Index) Mutual Fund
In this type of mutual fund the manager follows a published index (e.g. the S&P 500). They buy and hold the stocks in the index only selling or buying new stock when the index changes. The turnover in an index fund is usually very low, less than 10%. A low cost index fund has a management fee of roughly 0.15% or $1.50 per $1000 invested.
Why are Passive Funds a Better Choice?
Lower Management Fees
In order to just equal the index fund performance the active fund must out perform it by 1.2% per year (1.35%-0.15%). That may sound easy, but the number of actively managed funds that manage to do this is quite low. On average actively managed and passive index funds perform about the same before fees are considered. Once fees are added in then the actively managed funds underperform passive index funds. The longer the time period the fewer actively managed funds outperform low cost index funds.
Because actively managed mutual funds turnover their portfolio much more frequently than passive index funds they generate much higher short-term capital gains on stocks they held less than a year. Even if the investor does not sell their shares in the mutual fund, and reinvests all capital gains, they still will have a tax bill for the capital gains their mutual fund generates. The short term capital gains are taxed as ordinary income. These taxes can significantly reduce long-term performance.
A low cost passive index fund, generates much lower capital gains. Most of the gains for an investor are only realized when she sells her shares in the fund. Those gains are much more likely to be long-term capital gains which are taxed at a lower rate.
Actively managed mutual funds only disclose their holdings a couple of times per year. This means that a fund that is considered “Large Cap” may have significant holdings in “Small Cap” companies without disclosing it. This means that the investor has a different risk/return profile that he realizes.
A passive index fund is almost always invested in line with it’s published index meaning that the investor’s risk return/profile is in alignment with what she thinks it is.
So who is pushing actively managed funds?
Often actively managed funds are pushed by brokers who earn a commission from selling them, or a told to sell them by their firms.
Most independent experts agree that investing in low-cost passive index funds is a great strategy for most investors.
Here is a ‘quick and dirty’ tool that I found in Money Magazine (Feb 2011), that gives you a quick assessment to see if your retirement savings are on track.
For each age there is a savings factor (e.g. at age 30 the savings factor is 0.3). This means that if you want to retire at age 65 you need to have 30% of your salary saved by age 30. If you earn $100,000 this means that you would need to have $30,000 saved for retirement. At age 50 the factor is 4.5 which means that if you earn $100,000 you would need to have $450,000 in retirement savings.
Age Savings Factor
This table is a better estimate for younger ages when retirement is far off and you want a quick reality check. As you get closer to retirement so many other specific factors could affect your number (e.g. will you have a mortgage, will you move, will your lifestyle change, etc.) that it may be worth doing a more specific sophisticated analysis, or even seeing a Fee-Only(tm) Financial Planner.
Interesting article in today’s WSJ on delaying Social Security and simultaneously withdrawing from both Traditional IRAs and regular taxable accounts simultaneously to fund retirement.
May 21st, 2012
After many delays, 401k plan providers and advisers will finally have to begin disclosing their fees. Some of these fees may come as a shock to some employers who were told that their plans were “free.”
Providers will have to disclose what the administrative fees are for the plan even if they are bundled into the mutual fund expenses in the plan. Mutual fund fee will have to be disclosed to participants in terms of the annual cost per $1000 invested.
Many participants will be surprised to discover that they are paying 2-3% of their 401k plan balance in annual fees. High fee plans are often sold to small businesses that lack easy access to lower cost 401k plan solutions, and lack the expertise to decipher the hidden costs in a supposedly “free” plan.
Hopefully the new disclosures will serve as a wake up call for small business and get them to ask some tough questions to their plan providers. Read the article for more details.