Tax-aware investing.

• Author: Raasch, Barbara J.

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...