Tax-aware investing is the new mutual fund mantra. If you haven't factored it into your investment thinking, you probably should. Under the current tax law, with its lower capital gains rates, it really pays to minimize taxes.
J.P. Morgan Investments has assembled some eye-popping numbers to illustrate this point.- If you're in the top 39.6 percent federal bracket and take all your profits in less than a year, for example, $1 will grow to $10.44 in 40 years.
- If you turn over aggressive growth funds after holding for more than 12 months, qualifying for the 28 percent capital gains rate, $1 will grow to $16.14.
- If you turn over aggressive growth funds after holding for more than 18 months, qualifying for the 20 percent capital gains rate, $1 will grow to $22.03.
- If you hold a nondividend paying security for 40 years without selling, $1 will grow to $45.26.
Thus, the dollar grew to $10.44 at the maximum tax rate and almost 41/2 times as much at a zero tax rate. And that doesn't even take into consideration the impact of state or local income taxes.
No-load fund investors now have several ways to implement tax-aware investing. One of the easiest is to buy an index fund, says No-Load Fund Investor, one of the oldest and most reliable fund newsletters around.
"While most are very tax-efficient, we think the Schwab 1000 fund stands out. Launched in 1991, the fund has never paid a capital gains distribution."
The problem with index funds, however, is that their high volatility is not appropriate for everyone. No-Load Fund Investor recommends two tax-aware balanced funds that offer significantly lower volatility than index funds: Vanguard Tax-Managed Balanced and T. Rowe Price Tax-Efficient Balanced.
Tax-aware managers follow several guidelines, says NLFI:
- They seek stocks they are comfortable holding long-term. This often means investing in growth industries. When they do take gains, they want them long-term.
- They prefer capital gains to dividends. Thus their portfolios can be more volatile than those that emphasize dividend-paying stocks.
- They avoid concentrated initial positions.
- They try to avoid rebalancing the portfolio, since this realizes gains.
- They are quick to take losses so they can be used to offset gains.
- Their decision-making always includes taxes.