I understand why high net worth individuals with a significant amount of money invested through taxable accounts pay a lot of attention to the tax structure of their investments. If you are a high earner that taxably invests in REITs, for example, you could be looking at a 39.6% federal tax rate. If you live in a high state tax locale such as California, you could be looking at another 13.3% in taxes. A California doctor investing in a real estate investment trust in a taxable account could be paying out 52.9% of each dividend received.
To ward off the escheation of a high earner’s wealth, mutual funds have sprung up in recent years that advertise themselves as “tax managed mutual funds” that offer three benefits designed to appeal to high earnings:
First, tax-managed mutual funds adopt a preference for selling only those appreciated investments that have been held for one year or longer. This strategy enables high net worth investors to avoid the receipt of distributions that get taxed at the short-term capital gains rate of 39.6%. If something needs to get sold, it will be at the 23.8% top rate that applies to common stocks held for at least one year beyond the date of purchase.
Second, tax-managed mutual funds invest in no dividend and low dividend-yielding stocks so that the ongoing costs of ownership are minimized. Instead of receiving sizable dividend payments that get taxed at 23.8% along the way, tax-managed mutual funds focus on businesses with high retained earnings to maximize the amount of business profits that can grow undisturbed without the effects of double taxation.
Third, tax-managed mutual funds tend to examine their portfolios for stocks that can be sold at a loss each year to offset any taxes that would accrue from the sale of other appreciated assets that year.
A fourth benefit offered by some high-end tax-managed mutual funds is called “in kind distributions” which means that if you wanted to sell $250,000 worth of a mutual fund holding, you might be able to coordinate with the fund to receive $250,000 worth of Berkshire Hathaway stock that was planned to be sold from the fund that year. This helps the other fund-holders out because they won’t be taxed on the sale of Berkshire shares that are being used to meet the fund redemptions. Meanwhile, the individual that receives the Berkshire stock transfers direct control to the fund-seller rather than the fund manager about when to sell the stock and realize gains. This benefit is often value neutral to the fund-holder if he turns around and sells the in-kind distribution that he receives in exchange for giving up an equivalent value of shares in the fund.
Despite the admirable tax focus of these funds, I do recommend that high net worth individuals seek out publicly available tax-managed mutual funds for their own money.
Why? Because they don’t result in greater returns. From 1994 through 2016, the tax managed fund index delivered returns of 7.4% each year, or 6.5% after taxes for high income earnings. Over the same time frame, the S&P 500 delivered 9.3% annual returns or 8.4% returns after taxes due to high earners.
In other words, the tax managed mutual fund does not create any additional wealth for those high earners seeking to minimize their tax commitments. You’d get two extra points just by following the boring index route with the added sophistication actually costing you value.
You know why I think these types of strategies go awry? They have the wrong north star. The right question to ask is: “What action will create the most net-of-tax wealth consistent with taking the lowest risk of capital impairment over time?” If tax efficiency is your goal, you may find yourself engaging in tax loss harvesting with assets that are temporarily distressed and are set to provide higher returns from the low valuation base.
Also, investments that come with higher taxes can become so cheap that they are still the most attractive asset class for the high earner. Outside of financials, the most intelligent sector that a high net worth investor could have purchased in 2009 was real estate. Even if half the dividends were lost to taxes, the medium-term wealth created by the real estate class was worth the tax inefficiency because the low valuation more than offset for the high taxation.
Tax-managed mutual funds are on to something with their focus on retained earnings. Businesses like O’Reilly Automotive, Berkshire Hathaway, Visa, and Alphabet are probably some of the best investments for wealthy investors in taxable accounts because of the vast retained earnings that are being put to work at high rates. The tax efficiency of these holdings is an attribute that facilitates wealth, but shouldn’t be pursued for its own sake because the underlying rate of growth is the more controlling variable when you’re trying to build wealth.