Keep Your Eye on After-Tax Return
Ignoring taxes on investments can be costly, but don't overemphasize taxes, either
NEW YORK — What matters most in achieving wealth through investments?
Well, that depends on who's giving advice.
One set of experts will chant the refrain "total return," which measures both the profit from an investment and its dividends.
And that seems logical.
But another set of experts hears a sour note in that refrain, a note struck by the taxman.
Mutual fund companies favor "total return," making money through the highest possible returns, including reinvestment of dividends.
Fund-rating systems reflect that bias. The fund with the greatest return becomes king of the hill.
But many financial experts disagree. They argue that the single most important component of wealth building is the after-tax return of your investments.
Gaining wealth, says Len Reinhart, chairman of Lockwood Financial Services Inc., depends as much on what you keep after the taxman cometh, as what you earn before he shows up.
Traditional Wall Street firms and most mutual funds stress total return. A few rebels, such as Lockwood, based in Malvern, Pa., and investment house Brown Brothers Harriman & Co. in New York, emphasize the consequences of tax planning.
"Most individual investors would be shocked to see how much taxes can impact their long-term results," says Brian Berris, a partner at Brown Brothers.
Without careful tax planning, mutual funds can work against you, Mr. Reinhart says. Some mutual funds buy and sell stocks frequently over the course of a year. This high turnover can capture high profits, but also high taxes, since the fund's investors must pay a tax on the profits of those stocks.
Sometimes buying a mutual fund means buying a tax time bomb. The experts call it "unrealized gains."
When you buy into an equity fund, you inherit, on average, a 20 percent unrealized liability in capital gains taxes, according to Morningstar Inc., the fund-rating service in Chicago.
The tax arrives when stocks owned by the fund are sold at a profit. If you own the fund when the stocks are sold, you pay taxes on the profits.
Moreover, you are at the mercy of your mutual fund manager as to when the stocks will be sold.
Total return is not inherently bad, experts stress.
"If you've got a choice between two mutual funds, and one earns over 30 percent in one year and another fund earns 12 percent, heck, the answer is easy," says Frank Campanale, president of Smith Barney Consulting Group. "You should have invested in the fund that earned 30 percent and just paid your taxes. You still come out ahead."
Still, planning is crucial, Mr. Campanale says. Someone in the maximum tax bracket, for example, should be more concerned about owning low-turnover mutual funds than someone in the lowest tax bracket.
That usually means a fund that invests in large companies, the blue chips. Funds that buy stocks of smaller companies often come with a high turnover rate.
Before you buy a fund, ask about the turnover rate and the estimated impact of taxes.
Tax planning is especially crucial at the end of each year. You can take active steps to hold down your gains. Thus, you might offset gains in certain stocks or mutual funds with losses in other securities and funds. This strategy, however, can get complicated. Make sure you do lots of homework or seek advice from an accountant or financial planner.
Does tax planning make much of a difference? Take a hypothetical example of an individual who invests $100,000 in several stocks, and combined they earn 7.39 percent a year.
In 10 years, the portfolio's after-tax value would be $416,331 at the maximum tax rate, Reinhart says.
Compare that with a mutual fund that has 20 percent unrealized capital gain. Assuming you earn the same amount but the fund takes and distributes the 20 percent gain, your money would generate $36,000 less.