The Enlightened Investor: Is Your Portfolio Leaking Tax?

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It may be obvious to state that an investor only keeps the after-tax return. It is less obvious how to minimize the tax leakage from your portfolio.

A good starting point is to identify the two primary causes of tax; portfolio turnover and an inefficient portfolio structure.

Taxes resulting from portfolio turnover can cost you more than commissions or management fees. For example, while investors may know that mutual funds charge a Management Expense Ratio (MER), few are also aware of the Trading Expense Ratio (TER) – a separate fee charged to investors that pays for the fund’s trading of its securities.

 

John Bogle, founder of the Vanguard Group of Index Funds estimates the average mutual fund turnover to be upwards of 100% per year and “the average (hidden) cost of mutual fund portfolio turnover to be between 0.5 percent and 1.0 percent”.

He believes all actively managed funds should carry the following disclosure.

“The fund is managed without regard to tax considerations, and given its expected rate of portfolio turnover, is likely to realize and distribute a high portion of its capital return in the form of capital gains which are taxable annually”[1]

One solution for frustrated investors is to minimize trading activity in their portfolios or the securities they hold. Quarterly rebalancing with small adjustments is preferable to continual buying and selling of securities.

A second source of unnecessary tax is a poorly structured portfolio. For instance, most portfolios produce interest income, dividends and capital gains or losses and most clients have taxable and non-taxable accounts such as an RSP.

If investment returns are subject to different tax rates it is intuitive that aligning investments according to their income type with the right account can reduce tax on investment returns. This is called asset location for tax efficiency.

Less trading and a proper portfolio structure that aligns certain types of investment income with specific types of investment accounts are two ways of minimizing the tax leakage from your portfolio.

If you would like more information or have any questions, feel free to contact us at 780.466.6204, or click here to send us an email.

Thanks to Chris Turnbull of The Index House for providing this article.

Author of Your Portfolio is Broken: Who’s to Blame and How to Fix It.

The Index House is a division of Polaris Financial Inc.

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