After recently filing their 2013 tax returns, many Americans are just now realizing how much more they paid in taxes compared to years past. And for many, the biggest tax increase was on their investment income.
As a result of the recent tax changes under the American Taxpayer Relief Act (ATRA), the Tax Policy Center, on its website, predicted that 77 percent of Americans paid higher taxes in 2013 than 2012. ATRA increased the top tax rate to 39.6 percent, increased payroll taxes and phased out personal exemptions and itemized deductions for certain taxpayers. The new tax act also increased the top rates for long-term capital gains and qualified dividends.
In addition, 2013 was the first year certain investment income became subject to the 3.8 percent Medicare surtax. With the additional surtax, the top tax rate for long-term capital gains and qualified dividends increased to 23.8 percent in 2013, a 59 percent tax hike. The top tax rate for short-term capital gains, interest and ordinary dividends rose to 43.4 percent.
Trouble for portfolios?
Capital gains, dividends and interest can erode a portfolio's future returns on an annual basis. Unfortunately, most people don't think about how taxes could affect their long-term investment goals.
Morningstar measures the tax cost ratio of most mutual funds, and while some funds will have a low tax cost ratio, other funds can have ratios as high as 5 percent or more each year. This means that a mutual fund with a 3 percent tax ratio will surrender 3 percent of its returns to taxes each year. The tax drag will be greater for those funds that are actively managed and have a high turnover ratio.
The turnover ratio of a mutual fund is measured as a percentage of the fund's holdings that have been sold and replaced during the prior year. For example, if a mutual fund invests in 100 stocks and 50 of them are replaced, the fund would have a turnover ratio of 50 percent. The average actively managed fund has a turnover ratio approaching 100 percent. Because the fund's holding period was less than one year, this could result in a lot of short-term capital gains being distributed to the investor each year. This is true even if the fund loses value. In the current tax environment, that means those short-term capital gains can be taxed at a rate as high as 43.4 percent. In addition, periodic rebalancing of a taxable portfolio to maintain proper asset allocation will cause further drag on investment returns.
How do I control investment-related taxes?
Of course, you can't eliminate all investment-related taxes, but you can control them and improve a portfolio's efficiency. If the investments are for retirement, does it make sense to pay taxes now on income that will be used in the future?
