Issues affecting after-tax investment returns

An investment portfolio’s performance is influenced primarily by the asset allocation (investment) strategy the investor follows. However, taxes can lower investment returns and the amount of tax incurred varies by type of investment. An investment in common stock held for more than one year generally produces a mix of ordinary income (that is, dividend income), which is taxed at rates of up to 39.6 percent (federal), and long-term capital gains, which are taxed at 20 percent (federal). Income from other investments (for example, government or municipal bonds) may be exempt from federal and/or state income taxes. When constructing or maintaining a portfolio, investors should be aware of several issues that will affect their after-tax rates of return.

Fund Category: Mutual funds invest in different types of securities (for example, growth stocks, small company stocks, foreign stocks, corporate bonds, government securities). The investor’s total return varies by type of securities and the tax treatment afforded the income/gains generated by the fund. The following chart summarizes the tax efficiency of several different types of funds.

Tax Effect on Returns by Fund Category
Fund Category	Average Pretax Return	Average After-tax Return	Tax Efficiency
Growth	14.3%	11.8%	82.5%
Equity Income	14.1%	11.1%	78.7%
Growth and Income	12.9%	10.2%	79.1%
Small Company	15.2%	12.8%	84.2%
Foreign Stock	15.2%	10.1%	66.4%
Balanced	12.6%	9.9%	78.6%
Taxable Bond	9.2%	6.4%	69.6%
Source: T. Rowe Price and Morningstar.

Investments in mutual funds generate ordinary income as well as short- and long-term capital gains. In most cases, mutual funds are managed (that is, buy and sell decisions are made) without regard to the tax consequences for fund investors. Mutual funds are required to distribute earnings annually; consequently, investors do not control the timing of income from mutual funds. However, there are several tax-efficient mutual funds (that is, the fund managers consider the tax consequences of their buy and sell decisions). Tax-efficient mutual funds tend to

Turnover Rate: The extent to which a mutual fund manager buys and sells securities (turnover rate) can have a significant effect on the investor’s after-tax return. A 100 percent annual turnover means the entire portfolio changes every year, while a 50 percent turnover means the entire portfolio changes once every two years. Lowering the turnover rate defers realized gains and the related taxes into future years. Studies have shown that over a 20-year period, a portfolio turnover rate of up to 20 percent will reduce pretax returns by approximately two percent. Turnover rates between 20 and 40 percent result in another 0.5 percent reduction in pretax returns. A portfolio turnover rate in excess of 40 percent has only a slightly larger impact on pretax returns.

Selective Sales: The above statistics assume securities are sold on a pro rata basis for all investments held by the fund -- if high-basis securities are sold before low-basis securities, the turnover rate has a less dramatic impact on pretax returns. Portfolios that sell high-basis securities before low-basis securities can have a high turnover rate (80 to 90 percent) with only a two percent negative effect on pretax earnings (that is, the same effect that a 10 to 20 percent turnover has when securities are sold on a pro rata basis).

Loss Positions: Capital losses are an inevitable part of investing. Selling securities at a loss to offset capital gains may be prudent if another investment is likely to provide a superior return. Alternatively, the investor could recognize a loss (that is, sell securities at a loss) and, after 30 days, reinvest the proceeds in the same securities (the wash-sale rules must be considered).

Municipal Securities: Interest from municipal bonds generally is exempt from federal income taxes. If a municipality in the taxpayer’s state of residence issues the securities, the income is not subject to state taxes.

Tax-Deferred Accounts: Appreciation realized on investments held in tax-deferred retirement accounts will be taxed as ordinary income (rather than as capital gains) when withdrawn during the retirement years. When making investment decisions for tax-deferred accounts, focus on asset allocation issues and pretax returns (that is, building a diversified portfolio that will generate the returns needed to achieve retirement goals at an acceptable level of risk).

These are some issues to consider when making investment decisions. Your Deloitte & Touche financial advisor also can provide information and should be consulted before any action is taken.

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	Investments, after taxes Personal Finance Advisor by Deloitte & Touche OnLine April 12, 1999