By Gary Brooks, CFP
The impetus for my September 3 column in the Tacoma News Tribune (included below) was a review of capital market return assumptions from several prominent investment firms, consultants and market analysts. I’ve included a table here of these projected returns. The projections are applied to different timelines, generally from five to 10 years.We know these returns will be wrong but they are based on the best information available today and a lot of historical precedent.
In addition to the generally low return assumptions, it’s interesting to note that inflation is expected to remain low as well. At least that allows for a little bit more real, after-inflation return. We’ve debated whether or not to lower the inflation assumption in our long-term financial planning for clients. We’ve chosen to continue using a 3.0% assumption for plans longer than 10 years as this is the average of the past century.
Now for the News Tribune article about squeezing more return out of our investments by managing costs and taxes.
These ideas might improve after-tax return of investments
BY GARY BROOKS, Contributing writer – September 3, 2014
With U.S. stocks generally trading at a premium and bonds offering unattractive interest rates, expected returns for a balanced investment portfolio are projected to be relatively low over the next several years.
If potentially low returns threaten your progress toward your financial goals, there are components of your returns that you do have control over and can adjust to increase performance.
The first and easiest step is to understand your investment costs. You can likely reduce both the management fees charged by your investments and your transaction costs. But the area where you can possibly have even more effect on your return – albeit, not as simply in most cases – is to reduce the tax consequences of your investments.
The best investors understand these drags on return and consider them when deciding not just what investments to buy and when to sell but what type of account to hold them in and what the expected real return is after inflation, fees and taxes.
Consider these few ideas from a long list of ways to improve the after-tax return of your investments and retirement income. Any one of them applied to the right situation could be meaningful.
HARVEST GAINS TAX FREE
If you are in the 10 percent or 15 percent tax bracket – taxable income up to $73,800 for married filing jointly taxpayers in 2014 – sell investments that have done well in taxable accounts. Counterintuitive, yes. But in these low tax brackets, there is no capital gains tax on realized gains after at least a one-year holding period. You can use the proceeds of the sale to rebalance your portfolio and essentially get a step up in your taxable cost basis. This works for many retirees whose only current taxable income may be Social Security. Take advantage of this before annual distributions from IRAs and 401ks become required at age 70½, possibly driving you out of the 15 percent bracket for the rest of your life.
PAY UP AND GO ROTH
If you are likely to be in the same or higher tax bracket later in life consider a Roth IRA conversion. Many people who have been good retirement account savers see their tax bracket increase once they add retirement account withdrawals on top of Social Security and possibly pension income.
When you convert assets from Traditional IRA to Roth IRA, you pay ordinary income tax on the amount converted. But from there forward, the money grows tax free and there is no required minimum distribution each year after age 70. Consider this example: Joe Investor has $400,000 in an IRA. His adjusted gross income in 2014 is $125,000 putting him in the 25 percent married filing jointly tax bracket. If it appears he is likely to move up to the 28 percent bracket in the future, he could fill up his 25 percent bracket now with the Roth conversion. Joe could convert $23,850 to reach the top of the 25 percent bracket at $148,850. He would pay ordinary income tax on the amount converted at 25 percent rather than 28 percent in the future.
This strategy could be done for a series of years increasing the amount of money impacted by the three percentage point difference in tax. This example would save $715 and that savings would grow tax free in the Roth.
If you use non-retirement accounts to generate income you may be better off with stock dividends than bond interest payments. The maximum tax rate on qualified dividend income is 23.8 percent. The maximum tax rate on interest paid by bonds is 43.4 percent. Given low bond interest rates, high-quality dividend-paying stocks could produce better after-tax returns. Today’s 20-year Treasury bond rate of about 2.85 percent is just 1.6 percent after this high tax rate. By comparison, the Vanguard High Dividend Yield exchange-traded fund has an after-tax yield of 2.2 percent, more than a third higher.
You can certainly find many high-quality companies with higher dividends than this example. This route introduces more risk and only really makes sense in taxable, non-retirement accounts. Keep in mind that with stocks, risk is meant to be compensated for with potential for capital appreciation above and beyond the dividend. Also, when comparing the risk of reaching for higher bond interest in lower-rated bonds vs. the risk of dividend-paying stocks, it’s less of a difference than comparing stocks with government bonds.
There are several other ways to be more tax efficient with your investment accounts. Some of them, such as optimal location of different types of investments, are simple and apply to anyone’s situation. Of course, matters related to taxation have various rules that may apply to your situation. Consult with a tax professional to confirm the intended outcome before you act.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at email@example.com