The Tax-Efficient Frontier

Most men carry a wallet. Some carry a purse, but that's a whole other blog post. Most men carry their wallet in the same pocket every day. Personally, I feel it's more comfortable in my left pocket. If I have a hole in my preferred pocket, I reposition my wallet to the other pocket and it...well...feels uncomfortable. It feels kind of unnatural. Ladies, stay with me here; trust me, there's a point to my story.

[See top-ranked ETFs by category ranked by U.S. News Best ETFs.]

What happens when you have a hole in your pocket? You have to move your wallet to the other pocket so you don't lose any money through the hole. Guess what? You probably have holes in your investments that money is falling through in the form of unnecessary taxes. What should you do? Change pockets! With tax rates set to skyrocket in a matter of months, now is the time to consider repositioning your investments. It's time to put that wallet in the other pocket.

The following categorizes the most common investments by tax efficiency. Please note that this is not a discussion on investment performance, but one could draw the conclusion that the greater the tax-efficiency, the greater the return, especially for high-income earners. This is known as tax-adjusted returns, but I digress.

Mutual funds vs. managed stocks/ETFs. Many mutual fund investors will be surprised to know they may be losing a good chunk of their returns to the taxman. According to Morningstar.com, "[Mutual] fund investors are at a disadvantage when it comes to taxes. . . . [I]nvestors in conventional mutual funds can get stuck with a tax bill on their mutual fund holdings, even if they've lost money since they've held the fund."

I call this mutual fund phenomenon a double whammy: losing money in a fund because of a bad year in the market and getting a tax bill on capital gains even though you didn't gain anything.

See, mutual fund managers have the difficult responsibility of pleasing current investors while pleasing their marketing departments by posting returns that attract new investors. Because of this dual mandate, negative years in the market will typically compel the fund manager to sell an underlying investment that has a gain in order to lower the overall loss in the fund and voila, you get a tax bill for capital gains.

Mutual funds are like mass transit. They're not tailored to you; you get on with everyone else and you get off with everyone else. If you're concerned with lowering taxes, know that conventional mutual funds are one of the least tax efficient vehicles known to man. If you're comfortable with the ups and downs of the market, a professionally managed stock/ETF portfolio is more tax-efficient than conventional mutual funds because the tax strategy is tailored to your personal sensitivity to taxes. It's like riding in a limo compared to the city bus. Would you rather take the city bus or a limo?

As an added tax-saving bonus, you may even be able to deduct the management fee charged by your professional money manager. Goodbye whammy, hello tax efficiency!

Corporate bonds vs. municipal bonds. Bond investors buy bonds because they enjoy stable income (aka yield) and no market risk (except in the case of bond funds). There may also be an added benefit in the form of tax savings for some specific types of bonds. Corporate bonds offer no tax shelter because the interest income is subject to both federal and state income taxes. Municipal bond interest, however, is tax free at the federal level, and if the bond is issued within the state you live, it's also free from state income taxes. Because of their tax efficiency, municipal bonds pay a lower yield when compared to their tax-inefficient counterparts, corporate bonds.

This tax break can be huge if you're in a high tax bracket. The best way to evaluate the benefit of buying a tax-free municipal bond versus a taxable corporate bond is to calculate what's called the tax-equivalent yield:

Muni yield / (1 - your federal tax bracket) = tax-equivalent yield

So, using this formula, suppose you have a municipal bond paying a 5 percent yield and you're in the 28 percent tax bracket:

5 percent / (1 - 0.28) = 6.94 percent

This number (6.94 percent) is the tax-equivalent yield of the municipal bond, which is helpful when comparing a tax-free bond to a taxable bond. All things being equal (bond rating, maturity date, etc.), you would need a taxable bond to yield more than 6.94 percent to make it worthwhile for consideration.

Please note: All too often, I've seen other advisers misuse and abuse municipal bonds by putting them in the portfolio of a client that had no business being invested in them. Generally speaking, you shouldn't even consider this strategy unless you're in a 28 percent tax bracket or higher because you'll just be subjecting yourself to a low yield. Always use the tax-equivalent yield formula to compare apples to apples.

CDs vs. deferred annuities. CDs (certificates of deposit) over the years have earned the nickname "certificates of disappointment" because of their shameful return and terrible tax efficiency. The interest you earn on a CD is fully taxable, so you give up a large part of your return to the taxman!

If you have a $100,000 CD paying 1.50 percent, you earn $1,500 in interest over the year. If you're in the 28 percent tax bracket, you give up $420 in taxes, so the "real return" of the CD is 1.08 percent. This does not include the impact of inflation, which would put the "real return" of the CD into negative territory, but I won't even go there because this is a tax discussion.

Faithful CD owners love their CDs mostly because of the principal protection that they offer. Deferred annuity owners also love their annuities mostly because of the principal protection that they offer (in the case of fixed and fixed indexed annuities), but they also offer another significant benefit: They're far more tax efficient.

[See Equity-Indexed Annuities: The Magic Bullet?]

Interest earned on a deferred annuity is tax deferred (like an IRA), which offers protection from federal income taxes, state income taxes, and Social Security income taxes. In other words, a deferred annuity offers triple tax deferral, which over time can really add up to tremendous tax savings. Part of the magic of this strategy is understanding that not only is your principal and interest compounding, but so is the money on which you would have normally paid taxes.

What happens when the money comes out of a deferred annuity? The growth on the annuity is taxed as income (like an IRA), which is why many doctors and other high-income earners use deferred annuities as their preferred retirement savings tool.

Savings and money market accounts vs. life insurance proceeds. Savings and money market accounts share the same tax inefficiency that CDs do. Any interest earned is fully taxable, which can be a big chunk of your growth. What if you could put some of this "lazy money" to work and convert it from taxable to tax free? That's one thing life insurance is designed to do for you: take a relatively small amount of taxable money and parlay it into a much larger amount of tax-free money.

One of the few major tax breaks that the IRS gives you is the tax-free benefit on life insurance proceeds. Life insurance has been around since the 17th century, but people to this day are still surprised to hear about the tax-free death benefit that it offers.

[See What Type of Life Insurance Do I Need?]

It's all about taking advantage of the tax laws for the informed. Please note that there's tremendous controversy surrounding the various types of life insurance, but to set the record straight, insurance is NOT an investment nor should it be viewed as one. Life insurance is designed purely as an asset protection tool with tremendous tax benefits.

Robert Russell is CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to FOX Business and CNBC.

Securities offered through Kalos Capital, Inc., Member FINRA, SIPC. Investment Advisory Services offered through Kalos Management, Inc., 3780 Mansell Rd. Suite 150, Alpharetta, GA 30022, (678) 356-1100. Russell & Company is not an affiliate or subsidiary of Kalos Capital, Inc. or Kalos Management, Inc.



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