Taxable Fund Investment (Q & A)

Apr 2015


rick -2


Q         Dear Rick:

How can I avoid a relatively large tax bill and still take advantage of my taxable mutual fund investment?  Brief history:  until 2012 I did my own taxes for my wife and I, and I usually receive refunds from $500 to $1,000.  Most of the tax account was CDs which resulted in low interest payments.  In 2013 the taxable account was moved to various Fidelity mutual funds covering stocks and bonds.  Since then I have paid taxes to the IRS $1,550 in 2012; $1,140 in 2013 and $1,925 in 2014, based on dividends, short-term and long-term capital gains.  I sense that if I move the investments into a low expense index fund it may reduce the tax liabilities since the index funds are relatively stable.  Does my intuition make financial sense?



A         Dear L.P.:

I believe your focus is on the wrong spot.  You’re focusing on what you paid in taxes.  As far as I’m concerned, that’s not the right place to focus.  What you should focus on is what ends up in your pocket.  My belief is that even though you paid more in taxes, your investments made substantially more than they did in the CD and thus, even after paying the higher taxes you have more money in your pocket than before, which is exactly how it should be.


At many of my seminars, I always ask for a show of hands to anyone with a main financial goal to lower their taxes.  Inevitably, a fair number of people will raise their hand.  I always choose one of these people and ask them why they don’t want to win the $500,000,000 lottery.  Of course, they always respond that they do want to win the lottery. But then I point out that if one of their major financial goals is to lower their taxes and they win the lottery, it would increase them substantially.  Therefore, I say if your goal is to lower your taxes, you wouldn’t want to win the lottery.  Of course, I recognize that everyone would want to win the $500,000,000 even though it may cost them $200,000,000 in taxes.  The reason is that when it comes to the lottery, people will focus on what ends up in their pocket. Unfortunately, they don’t do that with their investments, which is a mistake.  I’ve always believed that you should never let the tax tail wag the dog; nor is it more patriotic to pay more money in taxes than you have to. Taxes are a necessary evil and it’s something that we all hate paying; however, it should not be our focus.  Our focus from an investment standpoint should be what ends up in our pocket.


In looking at whether index funds will reduce your tax liability, that may not be the case.  After all, index funds make capital gain distributions and they also have dividends, and in the case of bond funds, interest.  Therefore, from that standpoint I don’t think it would significantly lower your taxes.  An alternative is to consider some of the tax managed funds where the portfolio managers who run them implement certain strategies in an attempt to offset gains and losses.  Vanguard has a number of tax managed funds that you may want to consider.  The beauty of these funds is that not only are they tax sufficient, but in addition, they make good economic sense.  Of course, another great thing about Vanguard Funds is that they are commission free and they have very low costs.


I don’t want to say that taxes are not important, but they’re not the most important thing.  After all, particularly when it comes to investments, we’re talking about capital gain taxes and for most people that’s 20 percent or below.  Therefore, when people are focusing on taxes, they’re focusing on the 20 percent; not the 80 percent.  I choose to focus on the 80 percent because ultimately, that will put more money in my pocket, exactly where it belongs.


Our tax laws are complex and, unfortunately, are getting more and more complex.  In fact, over the last 10 years we’ve had more than one tax law change a day.  Therefore, for the great majority of people, what you think you know about taxes is generally wrong.  In addition, the great majority of investments, such as annuities are sold with the idea that they have great tax breaks and that is wrong.  In fact, in many situations like annuities, they don’t lower your taxes, they actually raise your taxes; and even more importantly, they don’t put more money in your pocket where it belongs.  The bottom line when it comes to our investments, we want to be smart with taxes but not let the tax tail wag the dog.  What we want to focus on, no matter the investment, is what ends up in our pocket after taxes.