Tax-aware investing.

Most people believe that the only way to increase investment return is to increase the risk assumed. This is frequently not true. Proper tax planning gives individual investors the opportunity to increase their rates of return without increasing risk. Risk-free return enhancement can be particularly substantial when the economy slows, causing the expected returns from portfolios to decline. Therefore, especially in times like these, use of tax-aware investment strategies can be extremely valuable.

A simple example of a tax-aware investment strategy is the determination of whether, on an after-tax basis, municipal bonds provide greater value than taxable bonds. If an investor is in the 40% marginal tax bracket and could buy a municipal bond paying 4.6% interest or a taxable bond with the same level of risk paying 6% (3.6% after-tax), he could increase his return by 100 basis points per year without increasing risk by simply selecting the municipal bond.

As a general rule, individuals subject to a marginal Federal tax rate of 28% or above will receive a higher after-tax return by investing in municipal bonds rather than comparable taxable bonds. However, this is not always the case. The bond's term to maturity, as well as factors such as the supply and demand dynamics of bonds and expectations concerning tax law changes, can cause different results.

The municipal bond yield ratio for short-term bonds is normally smaller than for long-term bonds; the yield on municipal bonds with a one-year maturity averages only about 70% of the yield on comparable taxable bonds. As a result, taxpayers frequently must be subject to a Federal marginal tax rate above 30% to benefit from purchasing short-term municipals. On the other hand, the yield on 30-year municipal bonds averages about 85% that of comparable taxable bonds. Currently, 30-year AAA insured municipal bonds are yielding 89.1% of the 30-year U.S. Treasury yield. Consequently, even taxpayers subject to a Federal marginal tax rate as low as 15% can earn a higher after-tax rate of return by investing in long-term municipal bonds. This is particularly true for individuals not subject to the alternative minimum tax (AMT), who can pick up an additional 10 to 20 basis points by purchasing private activity bonds subject to AMT.

Further, the municipal bond yield ratios for 10- and five-year maturities are also higher than average at 84.1% and 78.2%, respectively. As a general rule, when interest rates decline rapidly, municipal yield ratios increase; municipal bonds react more slowly to interest rate changes than U.S. Treasury bonds. Typically, the municipal bond yield change will reflect only about 70% of the Treasury change, making them more stable. Therefore, during times like these, high-bracket taxpayers receive an even greater risk-free return enhancement by investing in municipal (instead of taxable) bonds.

Importantly, tax-aware investing involves much more than comparing after-tax returns. To maximize after-tax returns, taxes must be taken into consideration in every phase of the investment process. The investment process is comprised of four phases: (1) the objectives phase, (2) the asset allocation phase, (3) the manager selection phase and (4) the portfolio evaluation phase. There is at least one important step that should be accomplished in each of these phases to enable individuals to minimize their tax burdens and, consequently, increase their after-tax returns. The following eight steps outline the actions recommended during the four phases:

(1) Identify Client Objectives:

Step 1--Determine the individual's cashflow needs by projecting current and future income taxes, as well as AMT exposure. Identify ways to reduce cashflow needs for taxes as well as ways to fund those needs through appropriate investment and income tax savings strategies.

Step 2--Forecast the value of assets expected to be remaining at death based on appropriate rate-of-return probability assumptions. To the extent these assets are expected to generate estate tax, compute the present value of these extra assets and, using one or more appropriate estate planning techniques, contemplate currently transferring them to heirs.

Step 3--Implement the desired strategies identified in steps 1 and 2 to minimize income and estate taxes. The best investment planning approach for high-net-worth individuals involves establishing and funding appropriate tax-savings vehicles before investments are selected. This avoids a potential "cart before the horse" syndrome, which can be costly.

(2) Asset Allocation:

Step 1--Identify the appropriate asset allocation, taking into consideration the tax attributes of the portfolio components (e.g., IRAs, trusts). Make sure to consider after-tax returns, as appropriate, when determining the asset allocation recommendations.

Step 2--Achieve the desired asset allocation mix in a way that minimizes income and estate taxes by effectively using portfolio components. Each portfolio component should have a separate asset allocation policy, based on the objectives of that piece of the portfolio and any opportunities that portfolio component presents to reduce taxes.

(3) Manager Selection:

Step 1--Select money managers and mutual funds based on an after-tax return evaluation. If a manager's or a fund's expected return potential is significantly greater than the competition but suffers from a low tax-efficiency ratio, consider using this manager or fund inside the tax-deferred portion of the portfolio.

(4) Portfolio Evaluation:

Step 1--Evaluate ongoing performance on an after-tax basis. Simply focusing on before-tax returns may not result in the most tax-effective conclusions.

Step 2--Make portfolio change decisions on an after-tax basis. Always consider how long it will take to "earn back" any taxes that must be paid as a result of the change.

Identify Client Objectives

The first phase of the investment planning process involves identifying applicable financial objectives, as well as an individual's financial situation. Many investment professionals do not spend sufficient time exploring individuals' goals and objectives. Often, they focus solely on the individual's risk profile and rate-of-return objectives when designing the investment strategy. This not only can result in the formation of an investment plan that fails to accomplish important financial desires, but can also fail to maximize wealth through minimizing taxes.

As part of this goal-setting phase, it is critically important to determine everything from the individual's monthly cashflow requirements to how much he desires to leave to heirs. In-depth discussions on these matters will not only assist the investment professional in formulating an appropriate investment strategy for an individual, but may also uncover opportunities for various tax savings techniques. Because most investment professionals do not have the tax knowledge and experience needed to properly advise high-net-worth individuals alone, it is imperative that the individual's tax advisers participate in these discussions as early in the process as possible. A coordinated effort by all the individual's advisers is necessary to ensure the investment plan is properly integrated with his estate and tax minimization plans.

Frequently, high-net-worth individuals are advised to establish irrevocable trusts, such as grantor retained annuity trusts (GRATs) and split-interest charitable trusts, to help meet estate planning objectives and to reduce tax burdens. The success of these strategies can be dramatically improved if the individuals' investment professionals team with their other advisers so that they have the knowledge needed to properly structure portfolios in a way that maximizes the tax reduction benefits. For example, a GRAT or a net income charitable remainder unitrust may result in significantly greater benefits if invested in growth-oriented stocks rather than bonds.

Asset Allocation

Asset allocation is the process of apportioning investment funds in various asset Categories (e.g., U.S. stocks, U.S. bonds, foreign stocks, foreign bonds). Investors' asset allocation decisions are the primary determinant of return. The optimal asset allocation is determined by finding the mix of asset categories expected to provide the highest return based on the investor's desired risk level.

Investment advisers typically use a mean-variance optimization model to determine this optimal mix of asset classes. This process requires assumptions as to the expected returns and risks of the various asset classes. These capital market assumptions result in significantly different portfolio recommendations when returns are reflected on an after-tax (as opposed to a pre-tax) basis.

Mean-variance optimization is a mathematical process that requires three inputs: (1) expected return of each asset, (2) expected risk of each asset and (3) the correlation coefficient of each pair of asset classes. Correlation coefficient represents the diversification effect of adding an asset class to a portfolio. If an asset is expected to be unaffected by the factors that affect the return of another asset class, adding this uncorrelated asset to a portfolio is beneficial to reduce the portfolio's overall risk. Risk is defined by the degree to which a portfolio's value varies over time. When all the portfolio's assets react in a similar way to the same economic events, the value of the portfolio will vary more, as every asset value will change in the same direction at the same time. Adding assets expected to be unaffected by the factors that have an impact on the existing portfolio's return reduces risk, because the value of these uncorrelated assets should not change in the same direction at the same time.

Adding asset classes (such as foreign bonds and foreign stocks) to a portfolio invested primarily in U.S. securities creates a beneficial diversification effect. However, because investors tend to care about maximizing returns and not just minimizing risks, the risk-reduction benefits of adding foreign securities will be advantageous only if the return rate of these foreign assets is sufficiently high. In addition, the expected asset return must be considered on an after-tax basis for individuals, as individuals only get to keep the portion of the return that remains after paying the related tax liability.

When after-tax returns are considered, certain asset classes that would otherwise be expected to provide a favorable risk-adJusted return effect on a portfolio actually become an inferior choice, because their after-tax return is insufficient to justify the risk. For example, foreign bonds are frequently added to portfolios because they provide a positive diversification for a U.S.-dominated portfolio. However, compared to municipal bonds, foreign bonds are generally considered inappropriate for high-income taxpayers; the after-tax expected return is too low to justify the risk on a relative basis.

Even though asset classes (such as foreign bonds) are expected to produce lower after-tax returns when held in a high-bracket individual's taxable portfolio, many individuals may still use these to diversify their portfolios by holding them inside a tax-deferred account. To the extent portfolios are comprised of taxable as well as tax-deferred accounts, proper use of the tax characteristics of these accounts can enable individuals to maximize the portfolios' risk-adjusted return expectation.

As a general rule, if the asset allocation policy calls for assets whose returns are primarily subject to current ordinary income taxation, it is best to place these assets inside tax-deferred accounts, rather than holding them in the taxable portfolios of high-income individuals. Examples of high-income-generating assets better held inside tax-deferred accounts include high-yield bonds, real estate investment trusts and foreign bonds not subject to foreign withholding tax.

A mistake that tax-unaware investors often make is investing in foreign stocks inside tax-deferred accounts. While the interest income earned on foreign bonds is frequently not subject to foreign withholding, the dividends paid by foreign companies are typically subject to foreign tax withholdings. When foreign stocks or American depositary receipts are held inside a tax-deferred account, any foreign tax withheld on dividend income will ultimately result in double taxation.

As a general rule, foreign withholding taxes are creditable against an investor's Federal income tax liability. Therefore, generally, any foreign tax withheld on dividend income is refundable as long as there is sufficient U.S. income tax imposed on that income in the current year or over the five-year foreign tax credit (FTC) carryforward period. In the case of tax-deferred accounts, this FTC is lost. In addition, foreign dividends will be subject to U.S. taxation when withdrawn from a tax-deferred account. Because the FTC cannot be used to offset this tax, the foreign dividends will be taxed twice. Consequently, investors should try to avoid holding assets subject to foreign withholding inside their tax-deferred accounts.

In addition to tax-deferred accounts, many high-net-worth individuals' family portfolios include trusts and other wealth-transfer vehicles. When making asset allocation implementation decisions, the expected return can be increased if the investor takes full advantage of the income (as well as estate) tax aspects of various accounts.

Individuals typically want to position assets expected to generate the greatest growth in wealth-transfer vehicles while investing tax-deferred accounts in assets expected to generate the greatest current income. Therefore, the asset allocation process for individuals can be complicated. To truly achieve a portfolio designed to generate the greatest return for the investor's given risk, the tax ramifications of each of the portfolio's components must be considered. Simply using a mean-variance optimization model to design the asset mix and applying it consistently to all the portfolio components precludes the investor from maximizing the return rate on a risk-adjusted basis.

Manager/Mutual Fund Selection

Tax-awareness affects the selection of professional money managers and mutual funds, as well as whether to use a passive investment or active management strategy.

Passive investment. A passive investment strategy involves investing the portfolio in a way that results in the returns of each asset category matching that of an index (e.g., investing the U.S. stock portion of a portfolio in the 500 stocks that make up the S&P 500). Typically, a passive investment strategy is accomplished with index mutual funds, or by engaging a professional asset manager to structure a portfolio designed to mirror each index chosen in the asset allocation.

Passive management involves holding a pre-determined basket of securities that only changes when the definition of the basket changes. Generally, none of the securities are bought or sold based on expected performance criteria. Rather, the decision to hold or not to hold a security is based on whether it is represented in the index being matched. Because the securities that make up an index usually do not change as frequently as active managers' portfolios do, the turnover rate of passive portfolios is relatively low. This low turnover rate generally results in maximum tax efficiency, as capital gains are recognized so infrequently.

The downside of a passive investment strategy is that the quality of the securities held in the basket is not generally considered. There is no expectation of achieving excess returns due to superior security selection. Active management, on the other hand, focuses on achieving returns that exceed the returns of an index. However, these excess returns will only be beneficial if they are sufficient to more than cover the associated tax burden, as well as the additional portfolio management costs.

As a general rule, the more efficient the market is, the less ability a manager has to produce excess returns. Therefore, passive investing can be particularly beneficial for the most efficient portfolio categories. For example, large U.S. companies tend to provide a great deal of information on their operations and future earnings potential to a large number of analysts. Because there are so many people evaluating the stock in terms of whether it should be bought or sold at its current stock price, it is reasonable to assume the stock is priced appropriately. The efficiency of this market makes it difficult to achieve excess returns great enough to justify all the costs associated with active management. On the other hand, securities such as small company stocks frequently sell at prices below their fair value, because too few investors know about them. This inefficiency in the marketplace presents opportunities for asset managers to achieve returns that exceed the additional trading, evaluation and tax costs.

Active management. To the extent a portfolio will be actively managed by a professional money manager, an investor should carefully select appropriate managers or mutual funds to meet the portfolio's objectives. While mutual funds are very beneficial entities that enable small investors to achieve inexpensive diversification and access to high-quality money management, the tax disadvantages of mutual funds can result in additional costs.

Capital-gain exposure is the tax disadvantage that many mutual fund investors accept. Capital-gain exposure is the degree to which securities held within a mutual fund have increased in value prior to the investor buying into the fund. Expressed as a percentage, it represents the capital gain new investors may have to recognize even though they have not earned it. For example, if a mutual fund has a 20% capital-gain exposure, for each dollar a new investor invests in the fund, 20 cents may become taxable as a capital gain (even if the amount invested does not go up in value).

When investing in mutual funds, investors are in essence purchasing a percentage interest in each of the securities held in that fund. Therefore, if an individual invests $1,000 in a fund that is now worth $1 million, he in essence owns one tenth of one percent of all the fund's securities. If the fund had purchased those securities for $800,000 over time and sells all these securities for $1 million tomorrow, the fund will recognize a $200,000 capital gain. Assuming there were no other capital gains or losses recognized during the year and this $200,000 is distributed to the mutual fund shareholders when the individual still owns one-tenth-of-one-percent interest, he would have to recognize a $200 capital gain on his investment, even if the value of the interest in the fund plus the distribution he receives results in no actual gain.

Paying tax on a capital gain can be particularly painful if the value of an investment actually went down. Many mutual fund investors experienced that pain this past year, even from a fund with the term "tax-sensitive" in its name. When making a decision as to which mutual funds to use for the taxable portion of a portfolio, it is important to review statistics such as the capital-gain exposure. Frequently, mutual funds called "tax-sensitive" or "tax-efficient" have the highest capital-gain exposure percentages because of their buy-and-hold strategies.

A buy-and-hold strategy means the asset manager plans to invest for the long term instead of chasing the "hot dots." While chasing hot dots may result in greater gains, for taxable investors, those gains may be less beneficial in after-tax terms if they are entirely subject to current ordinary income taxation.

A professional money manager's or mutual fund's propensity to produce taxable income can be ascertained to some degree by reviewing historical turnover rates. If the turnover rate has been high historically, as a general rule, an investor can expect to recognize capital gains faster and therefore pay tax sooner.

Turnover rates of less than 25% can generally improve the after-tax performance of a taxable portfolio (all other things being equal). Below 25% turnover, the additional after-tax return pick-up can be dramatic. However, turnover rate can be a very misleading statistic. The turnover rate of tax-efficient money managers will often be higher than would be expected, because they practice "loss harvesting" (i.e., selling loss positions in a portfolio, when appropriate, and using the resulting losses to offset against gains). The practice of loss harvesting often results in two sales (as opposed to just one) every time a gain is recognized. Even though the second sale results in the recognition of a loss that has a positive tax impact, the money manager's (or fund's) turnover percentage does go up.

In the same way that an individual cannot always believe the term "tax-efficient" in the title of mutual funds, he cannot always assume that a higher turnover rate for asset managers and mutual funds is a tax disadvantage. It is important to analyze the turnover rate carefully to avoid making an erroneous conclusion.

It may be easier in the future to assess the tax efficiency of mutual funds. New Federal rules now require funds to disclose their after-tax returns in their prospectuses. As of April 2001, funds must disclose after-tax returns for one-, five- and 10-year periods, using the top Federal income tax rate.

Portfolio Evaluation

It is not only important to review the historical returns of prospective asset managers and mutual funds on an after-tax basis during the selection process, but it is also essential to evaluate the after-tax returns actually produced by taxable portfolios. Even though the Association of Investment Management and Research has issued a procedure to instruct investment professionals on how to compute after-tax performance, few investment professionals routinely perform the computation because they do not have software that easily accommodates it. When advising individuals, it is important to require that this computation be performed to ensure that the performance of the taxable portfolio is being assessed appropriately.

Most individuals should prefer to earn a lower return with a tax-efficient manager than a higher return from a manager that disregards taxes. For example, if Manager A produced a rate of return of 10% per year while Manager B produced a return of 8% annually over the same time period with the same risk, which one had better performance? If the 10% annual return was comprised entirely of ordinary income and the investor's combined Federal and state income tax rate is 45%, the after-tax return drops to 5.5% per year. On the other hand, if the 8% annual return was taxed entirely as a long-term capital gain, the investor keeps 6% per year.

Money managers who are truly tax-efficient are willing to continue to hold a security with a low-cost basis even when they expect the return to be less than that of an alternative investment. Instead of simply selling the security, they consider the after-tax proceeds and how long it will take for those after-tax proceeds invested in that new security to exceed the existing security's expectations. High-income taxpayers tend to prefer this analysis for the taxable portion of their portfolios.

Summary

Most investment professionals fail to give the optimal weight to tax considerations when planning and implementing individual investors' portfolios. Tax advisers can play an important role in helping investment professionals to identify ways to maximize wealth, if the tax advisers help the investment professionals to employ tax-saving strategies in every phase of the investment planning process. The eight steps presented should be added to the investment planning process for individual investors. These eight steps include everything from forecasting income and transfer taxes throughout the individual's life, to computing return rates in after-tax dollars.

In initial discussions with individuals about their investment objectives, advisers should be looking for ways to minimize taxes through tax-advantaged investment vehicles, as well as other strategies designed both to achieve the individual's objectives and minimize tax burdens.

In the asset-allocation phase, the tax characteristics of the individual's portfolio components (e.g., tax-deferred accounts, trusts) should be considered when identifying the asset classes to be used, as well as the implementation plan for the asset-allocation policy. When selecting professional money managers and mutual funds, rate-of-return expectations must be performed on an after-tax basis, and tax attributes such as turnover and mutual funds' capital-gain exposures must be considered for the taxable portion of the portfolio. Similarly, when a portfolio's performance is evaluated, it should be measured in after-tax dollars to gain a thorough understanding of the success of the managers and the investment strategy.

Adding these steps to the investment planning process of individual investors should result in considerably greater after-tax wealth generation opportunities for high-net-worth taxpayers.

Barbara J. Raasch, CPA, CFA, PFS Partner-in-Charge of Investment Advisory Services 

Anthony G. Amitrano, Jr., CPA, M.S., Tax Senior Tax Consultant

Ernst & Young, LLP New York, NY