- Many investors do not consider taxes when investing in equities, nor can they quantify the tax drag on their portfolios.
- Equities may wield an inherent tax advantage over many other asset classes, as long-term capital gains are taxed at lower rates than ordinary income.
- Employing the use of equity mutual funds managed for after-tax returns may further help exploit the tax advantages inherent in this asset class.
When it comes to investing, we believe the most important thing is determining not what you make, but what you keep. Unfortunately, investors in equities and equity funds may not consider or even be able to quantify the impact of taxes on their portfolios. Tax management within mutual funds seeks to maximize after-tax returns, and with good reason: Performance after Uncle Sam has taken his share can make a big difference in wealth accumulation over the long term.
There is no better time to get educated on the impact of higher taxes. Tax legislation enacted in 2013 has led to a dramatic increase in the taxation of long-term capital gains. The increase in rates from 15% to 23.8% means that many investors in the highest tax bracket will pay almost 60% more of this tax relative to 2012 (as the chart below shows). This can have a major impact on the long-term growth of an investment portfolio. Many investors are now sitting on significant embedded capital gains for the first time in several years, compounding the issue of higher taxes.
A tax-managed equity strategy may employ a number of techniques to help ease investors’ tax burden, including taking steps to minimize capital gains and avoiding fully taxable dividend income. More specialized investment products may be customizable to a client’s specific needs by harvesting certain capital losses to help offset gains realized elsewhere in a portfolio. These types of strategies may be particularly timely, given the record highs U.S. equities have recently reached (as measured by the S&P 500).1
The potential tax advantages of equity investing
Equities may wield an inherent tax advantage over many other asset classes. This is primarily because much of a stock’s (or stock fund’s) total return may come from long-term capital gains, which are not taxed until paid out and, even then, are taxed at lower rates than ordinary income. Likewise, under the 2013 fiscal cliff deal, qualified dividend income will still be taxed at the lower long-term capital gains rates.
Still, taxable equity investments may be quite vulnerable to the tax drag. A research study conducted by Lipper in 2010 attempted to quantify the tax drag on investor portfolios. Over the decade ended 12/31/2009, the average equity fund posted an average annual total return of 2.10%, of which nearly half (0.98%) was consumed by taxes.
Despite the significant bite taxes may take out of investment returns, many people don’t consider taxes when choosing their investments. At Eaton Vance, we believe taxes are a form of risk investors cannot afford to ignore — especially since higher taxes have become a reality for many as Uncle Sam comes collecting for 2013. Now may be the time to consider investing in equities — and tax-managed equities, in particular.
What is tax-managed equity investing?
As with other types of investments, tax-managed investing may help defend against the tax drag on equities. Mutual funds make distributions in the form of net investment income or realized gains. Taxable investors pay taxes on these distributions, regardless of whether they receive or reinvest them.
Most stock funds are run with little or no regard for investors’ tax liability. Due to the evolution and growth of tax-deferred accounts, such as 401(k)s and IRAs, many investment managers have been less focused on managing their equity mutual funds with taxes in mind. These qualified accounts have altered their behaviors to include shortened holding periods, increased trading frequency and, ultimately, more potential capital gains distributions.
Particularly in today’s higher-tax environment, net performance may look far less competitive after accounting for taxes. By contrast, tax-efficient equity funds are managed with a disciplined focus on enhancing after-tax investor returns. Such funds may employ a wide array of strategies and techniques to help achieve this objective, including:
- Taking a long-term perspective (i.e., five years or more) to delay capital gains recognition and help ensure that any gains will be taxed at the lowest possible rate.
- Maintaining low portfolio turnover in an effort to avoid short-term capital gains, which are taxed at higher ordinary income rates.
- Selectively harvesting and/or carrying forward capital losses to help offset gains taken elsewhere in the portfolio.
- Following holding period rules so that any dividends qualify to be taxed at the lower qualified dividend income (QDI) rate.
- Using tax-advantaged hedging techniques as alternatives to taxable sales and specific lot accounting to help minimize capital gains realizations.
Why choose a tax-managed approach to equity investing?
The tax drag on equities has historically been a cyclical phenomenon, and the evidence suggests that we may now be in the throes of a harsher cycle: 1) The maximum long-term capital gains rate has increased from 15% to 23.8% (including the new 3.8% health care tax) for high-income taxpayers. 2) Capital gains distributions from stocks and equity funds appear poised to keep rising from historic lows in the wake of the stock market’s triple-digit rally since March 2009, as the chart above shows.
Offsetting taxes has not been a high priority for some investors who have had losses embedded in their portfolios since the financial crisis in 2008. But given the cyclical nature of capital gains, tax-managed equity investing may provide several advantages, including:
- It can help cushion the effect of recent (and possible future) increases in income tax and capital gains rates.
- A long-term, buy-and-hold strategy with appreciated stocks can reduce the frequency and dollar value of capital gains distributions, and the rate at which they are taxed.
- For many investors, a combination of rising capital gains payouts industry-wide and higher tax rates could enhance the attractiveness of tax-managed equity investing.
1Standard & Poor’s (S&P) 500 Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance. Please see important information at the end of this Insight.
Eaton Vance does not provide legal or tax advice.This material is not intended to act as such advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel prior to investing.
Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance.
Equity investing involves risk, including possible loss of principal. Investments in equity securities are sensitive to stock market volatility. The ability to utilize various tax-managed techniques may be curtailed or eliminated in the future by tax legislation or regulation. Market conditions may limit the ability to generate tax losses or to generate dividend income taxed at favorable tax rates. There is no assurance or guarantee that any company will declare dividends. There is also no assurance or guarantee that, if declared, dividends will remain at current levels or increase over time. There is no assurance that the objective of any investment strategy will be met. Diversification cannot ensure a profit or eliminate the risk of loss. Past performance is no guarantee of future results. Indexes are unmanaged. It is not possible to invest directly in an index.
The views expressed are those of the Eaton Vance and are subject to change at any time based upon market or other conditions. Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.
About Eaton Vance
Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.
Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.
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