Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I recently visited Vanguard where I sat down with Joel Dickson, who is senior investment strategist and principal in the firm's Investment Strategy Group.
We discussed what changes lie in store for investors as they think about their 2013 tax returns.
Joel, thank you so much for being here.
Joel Dickson: Glad to be here, Christine.
Benz: You are one of Vanguard's tax experts. So, I'd like to get your take on what higher tax rates for high-income earners could mean for investors' portfolios. Are there any big takeaways that you would impart, given the potential for higher tax rates?
Dickson: I do think one of the things we have to keep in mind is that, really for the vast majority of people, we didn't see tax-rate increases in 2013, even with all of the discussion about …trying to get additional sources of revenue from taxpayers. But there are a couple of things that come into play. One is certainly higher income tax rates if you're above the $400,000 income level. And then for single filers around $200,000 and joint filers around $250,000, you have this additional 3.8% Medicare surtax on investment income, or passive income, that can come into play. So there are these two different thresholds: at about $200,000 and about $400,000.
But I think the broader point of higher tax rates is, it actually makes deferral more valuable. So if you can think about deferring taxes into the future, that becomes a little bit more valuable if you're facing higher tax rates in 2013 versus 2012.
Beyond that, a few somewhat interesting planning issues come into play as well, because anytime you have a threshold where you cross that and all of a sudden your tax rates change meaningfully, then there might be, for those that are around that threshold, some additional considerations that you might want to take into account.
So, for example, if you're doing a Roth conversion in 2013, you want to be careful that you don't bump yourself into a higher tax bracket. Well, now, bumping yourself up might also include making other investment income completely unrelated to a Roth conversion taxable if you bump yourself into that Medicare 3.8% surtax threshold. So, there are a lot of these different little planning situations that now need to be taken into account because of the higher rates.
Benz: What is your advice to investors in terms of trying to navigate these changes? Should they work with a tax advisor? Use some good tax prep software? All of the above? How would you recommend investors proceed?
Dickson: Very much all of the above. For my own situation, I actually have an app on my iPhone where I'll run through different scenarios as I'm thinking about different things. But tax preparation software, where you can model a $1,000 increase in your income and see what it does to your bottom-line tax liability, and different sources of where that $1,000 might come from, for example, in order to calculate an effective marginal tax rate and make decisions that way. Or your accountant and financial advisor can really help with navigating all of these very different and often very complex financial-planning and tax considerations.
Benz: I'd like to talk to you about the tax outlook for 2013 in terms of fund capital gains. I know it's still early days in the year, and we probably don't have a clear sense of which types of funds will make distributions, but it has been a very good year for the equity market. Sometimes we do see distributions after a year like this one. Do have a sense of the categories that might be most likely to make distributions?
Dickson: It's not only been in a good year for the equity markets this year, generally, but it has been good now for several years…
Benz: It's been a good run, yes.
Dickson: … and that is really often a determinant about capital gains realizations and ultimately distributions, is that build-up of returns over time. Usually, where you'll see them is with a lot of active managers, now you've gone through a lot of capital losses that maybe were incurred in the 2008-2009 timeframe, and now you're at the point where you may be distributing capital gains again.
So, while we're talking right now in the middle of October and really fund tax distributions aren't determined often until the end of October, you can [still] get a sense of where things stand this year, and I think most likely investors are going to see probably somewhat higher capital gain distributions in a number of active equity funds, … and even broad-based equity funds that have fairly high turnover rates and a lot of changes in the underlying portfolio. Certain sector funds that have been doing well will probably see capital gains as well.
I think you'll see somewhat fewer capital gain distributions or lower amounts this year in fixed-income funds, relative to what investors have seen in the past couple of years, in part because rates have not fallen as much, and, in fact, we had some periods of rates spiking up in the summer this year. So, on the fixed-income side, probably a little bit less in terms of capital gain distributions.
And on the index side, I think you're still going to see probably very muted capital gain distributions in the ETF and index mutual fund landscape just due to the nature of the portfolios and how they're managed, and ultimately there is a consideration in aftertax return, quite often, from how those portfolios are being administered.
Benz: In terms of how investors should use this information, if they want to try to be pre-emptive … Obviously, if you're about to buy a fund and are doing your due diligence, calling the fund company or seeing if there is some distribution pending before you buy a new fund [is a good idea]. But how about if you've been a longtime owner? Sometimes I talk to investors who want to try to get fancy and maybe get out before the distribution. What do you say about strategies like that?
Dickson: A couple of things around the so-called buying the distribution piece. First of all, for most investors, I wouldn't even worry about it until just shortly before any distribution might be paid. First of all, many fund companies will issue estimates, and so you will have a sense, close to the time of the distribution, what size the distribution might be and when it's coming. And you can then use that information in your own planning.
But one of the things that we often caution about is, don't overreact to a capital-gain distribution, because ultimately you're trying to maximize your aftertax return, and by, for example, selling to avoid a capital-gain distribution, you may just end up realizing all of your existing gain on the position that you hold instead of getting just a portion of that gain given to you in the form of a capital-gain distribution. It's kind of like cutting your nose to spite your face, because you're going to end up with a higher tax bill from that knee-jerk reaction of just trying to avoid the distribution.
That said, if there is a large distribution that may be coming into play around the time that you're thinking of making a purchase--within a couple of weeks or so--then you might consider just delaying that or finding another option that is similar where there might not be a distribution, just to avoid a short-term acceleration of your tax liability.
Benz: On a forward-looking basis, when investors think about tax management in their taxable portfolios, the types of funds that they generally want to avoid for those types of accounts, you mentioned high-turnover equity funds tend to be a bad idea. Any other categories where you would say, keep it out of your taxable account because you'll be contending with situations like this?
Dickson: Generally, the rule of thumb is the less tax-efficient the strategy is, the more you want to keep it out of taxable accounts and put it into tax-deferred accounts.
Benz: So bonds, certainly.
Dickson: Taxable bonds. And that's why, in fact, one of the things that I worry about a little bit in investors' single-minded focus on capital-gain distributions is they start talking about capital-gain distributions, for example, in bond funds. Well, bond funds, for many investors, should be avoided in taxable accounts. And so, if it's in a tax-deferred account, a capital gain distribution or an income distribution just doesn't really matter.
And so, investors looking to maximize aftertax returns, as a rule of thumb, will want to think about filling tax-deferred space first with taxable bonds, corporate and government bonds, and active equity funds or other inefficient asset classes--even something like REITs, for example. And save the space in their taxable accounts for broad-based equity portfolios, tax-efficient funds, whether active or passive--although, I think there's somewhat more reliance on passive being a longer-term strategy from a tax-management standpoint. And for those that do hold bonds, and especially high-income investors, maybe muni bonds in that taxable account.
Benz: OK, Joel, thank you so much for being here to share your insights.
Dickson: It's a pleasure, Christine.