Do you know how to calculate after-tax returns?
Our just-released Financial Professional Outlook survey was all about tax-aware investing. And while we covered the topic from a number of angles, the question that required the most thought was about how advisors calculate their clients’ after-tax returns .
As we reviewed the results and thought about our own conversations with advisors on this topic, we realized the question isn’t as easy to answer as you might expect. In fact, it generated the fewest responses in our survey. So we’re devoting a little more time to helping advisors gain a better understanding of the calculation. But first let’s look at what we asked and what we heard.
While the question was straightforward, it turns out that answering it correctly wasn’t. In fact, 38% didn’t answer the question and 16% said they don’t calculate after-tax returns. The responses seemed to get cloudier from there.
The process of calculating after-tax returns may seem confusing or onerous at first, but it really is a worthwhile exercise. If you don’t know the portfolio’s after-tax return and some basic info about your clients’ tax status, how do you know if you are helping them grow their after-tax wealth. How can you define success?
To properly calculate your clients’ after-tax return, you need to consider the distributions coming from the underlying investments. For simplicity’s sake, we’ll limit this discussion to mutual funds. individual stocks and bonds .
Identify the distribution.
In our Financial Professional Outlook survey, several advisors said they apply their clients’ marginal tax rate to the investment return. That’s not necessarily correct. The after-tax return should focus on the actual distribution and/or realized gain for that year – not the rate of return.
Why you ask? Consider this scenario: If the investment return was through a price increase in the underlying security (appreciation) without an actual distribution or realized gain, this unrealized gain does not owe any taxes at this time. Deferring this recognition can have a powerful compounding effect over time. So be sure to identify the amount of the distribution first and take into account the fact that at some time in the future, taxes may be due and the future rate may be different from the current rate..
Mutual funds can do some of the work for you.
Regulators require certain fund types to publish after their after tax returns. They’re just not always easy to find. At Russell, we publish that information for our mutual funds on Russell.com on a daily basis. You can also use a third-party vendor like Morningstar for after-tax return calculations. Both Russell and Morningstar use the methodology that regulators mandate, which assumes the highest Federal marginal rate applied to the fund’s distributions.
This works if your client is in the top tax bracket (for example, adjusted gross income > $450,000 for Married Filing Joint in 2013). But there is no accommodation for state income taxes. The state tax is an additional tax drag and can be meaningful for those in the higher tax states.
If your client is in the top bracket and invests only in mutual funds, you have a head start on trying to calculate the after-tax return of the total portfolio. And that’s the number that likely matters for taxable investments.
The list below is not intended to be all-inclusive or specific for all of your clients, but identifying the following numbers can be a beneficial step in preparing to calculate a client’s after-tax return . Ask yourself:
- What is the amount of your client’s
actual distribution during the calendar year?
- What is the character of the distribution. Was it interest income? Qualified or non-qualified dividends? Long-term capital gains (LTCG) or Short-term capital gains (STCG)?
- What is your client’s specific tax rate. Be sure to consider:
- Marginal federal and state tax rates (the tax on the next dollar earned) for gains taxed as ordinary income. STCG and gains from other assets are taxed at the marginal rate.
- The new 3.8% Medicare tax. if applicable. This is tied to investment income (interest, dividends, capital gain distributions) for clients with modified adjusted gross income high enough to cross the threshold. For 2013, that was Modified Adjusted Gross Income > $250,000 for Married Filing Joint status.
- Does the client have capital losses outside the portfolio you managed or a capital loss carry-forward to offset against distributed gains? If so, these may be able to be used to offset the current distribution.
Once you’ve done your prep work, it’s a pretty straightforward calculation to determine after-tax return. Just follow these steps;
- Apply the correct tax rate to the calendar year distribution. Use the top marginal rate for STCG, taxable interest, non-qualified dividends or other items treated as ordinary income. Use the LTCG rate for qualified dividends and capital gains held greater than one year.
- Do the calculation *:
(ending market value – tax paid) – (beginning market value)
(beginning market value)
The result is an approximation of the client’s after-tax return . Note that if the taxpayer qualifies for the Alternative Minimum Tax, results may vary.
It may help to look at an example. Here is the math for a hypothetical fund that appreciated in line with the U.S. equity market in 2013. In this case, gains are treated as short term (taxed as ordinary income).
‘*If shares are sold at year-end, taxes would be due on the appreciation of shares and would reduce after-tax return.
Not too daunting, right?
The bottom line
Calculating after-tax returns for your clients is worth the effort – how else can you determine whether there may be opportunities to employ strategies to help maximize your clients’ after-tax wealth?
This is powerful information to know and share in client reviews. Because who cares the most about this topic? As we heard in the Financial Professional Outlook survey. it’s high net-worth investors. And who couldn’t use a few more of those.
* The ending market value in this equation assumes distribution was reinvested.
Russell Financial Professional Outlook is a product of Russell Investments, produced independently of Russell’s investment and manager research services.
The information contained herein has been obtained from sources that we believe to be reliable, but its accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein result from surveys of persons outside Russell Investments and may not represent the opinion of Russell Investments, its affiliates or subsidiaries. This report is provided for general information only and is not intended to provide specific advice or recommendations for any individual or entity.
This is not an offer, solicitation or recommendation to purchase any security or the services of any organization.Please note, advisors surveyed do not necessarily use Russell products.
Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.
Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.