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Cut your taxes NOW!
Usually, people look for tax saving ideas at year-end. You can affect your taxes then – usually by shifting income or expense between years to defer taxes or pay more favorable rates – but, why wait? This article will discuss steps you can take in any season. You get the benefits starting now, and for the rest of your life. We’ll focus here on two simple tactics you can use to structure your investment portfolio, thereby reducing your tax bill, year in and year out:
- Buy index mutual funds (including index exchange traded funds, or ETFs) rather than managed funds for your equity investments in taxable accounts (index funds’ advantage is magnified in taxable accounts).
- Contribute to your IRA or Roth IRA, Coverdell or 529 plan now (the earlier in the year the better!).
Each of these powerful ideas saves you taxes all year long, year in and year out. Each tactic applies one basic tax reduction strategy: put off paying (defer) taxes as long as possible.
Here’s how, and how much, you can reduce your taxes with each tactic.
1. In your taxable accounts, you get maximal tax deferral of capital gains by not taking them until you need the spending power. Buying equity index funds is an excellent way to wait. You may have heard horror stories about people who bought a mutual fund, watched it go down, and then had to pay significant taxes because the fund had realized capital gains – pre-existing shareholders sold the fund, forcing the portfolio manager to sell some positions with embedded capital gains. This is less likely to happen in an index fund for several reasons:
- A larger percentage of index fund investors are "buy and hold" investors.
- If the index is down, most of the constituent securities are likely to be down also.
- If the index fund is also an exchange traded fund (ETF), you realize gains only when you sell the fund – your basis is your purchase price.
How much can the extra tax deferral from index funds and ETFs be worth? Suppose you put $10,000 into an equity mutual fund that you expect will return 7% annually over the long term, of which 2% will come from dividends1. Assume that index mutual funds will distribute 10% of their capital gains (CG) each year, while managed funds will distribute 50%2. The "Annual" column assumes that you sell your managed fund each year, and buy a new one. In this case, you will realize 100% of the capital gains each year. ETF capital gains usually are realized only when you sell, so the realization rate is 0%.
 If your time horizon is short, the advantage is small: in the first 5 years, the index advantage is only $130, the ETF advantage, $165 (1.3% - 1.5% of the original investment). If you are prepared to wait 20 years (as most of us investing for retirement are) the advantage is significantly greater: $1,600 for the index, and over $2,000 for the ETF (16% – 20% of the original investment). The longer you can wait, the greater the advantage. Of course, if your initial investment is $50,000, multiply your savings by 5, if it’s $100,000, multiply by 10, etc.
This example also illustrates the advantage of buying and holding – the tax saving from buying and holding a managed fund versus trading every year is nearly as great as the advantage of the ETF over buying and holding the managed fund. Chasing return by selling your current holding and buying the "hot" fund can reduce your net return significantly by raising your taxes.
By the way, this analysis estimates only the tax advantage of index funds and ETFs. Both also enjoy large cost advantages. These cost savings add to the tax advantage, making the case for index/ETF investing even stronger.
 2. Contribute to your IRA or Roth IRA, Coverdell or 529 plan now (the earlier in the year the better!). This saves taxes by moving assets from a taxable account to a tax-deferred account now – postponing tax payments on the earnings until you withdraw the assets, probably a long time from now. The table shows the spending power impact of annually accelerating your $4,000 deductible IRA contribution, and the equivalent ($2,600) Roth IRA contribution. The example assumes 7% return on assets and ordinary income tax rates of 35% pre-retirement and 25% post-retirement. Changing tax rates has minimal impact on the outcome, although higher returns do magnify the impact. Basically, making every contribution early in the year defers the taxes on every contribution for a year – that’s how the benefits add up.
If you’d like to hear more about ways to save on taxes or deferring tax payments while building a nest egg, give us a call. We’re happy to talk with you about your investment options and find a solution that’s right for you.
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