Managing Tax Efficiency & Fees in Investing
As a CPA financial planner, I often see many tax inefficiencies in portfolios and a multitude of hidden fees unknown to the prospective client.
Since I am a CPA, taxes are always top of mind. How a portfolio is arranged, meaning which investments appear in which types of accounts (retirement, taxable) can have a big impact on tax liability and what lands on form 1040 as taxable income. If tax efficiency is not utilized by the financial advisor, the client may end up with additional taxes on investments (interest, dividends, capital gains) that may be otherwise avoided. Further, depending on the types of investments in a portfolio, there may be hidden and additional fees also not known by the client. For example, if a portfolio contains mutual funds the funds themselves have fees and hidden transaction cost fees commonly referred to as a turnover rate. These hidden costs must be added to the annual expense ratio of the fund to determine the true cost of the fund. And, if mutual funds are held within a taxable account, the prospective client may incur taxable capital gains that are disbursed by the fund itself whether or not any shares of the mutual fund are sold by the client. So, even if the fund lost value (unrealized) for the year, there still could be a taxable gain landing on the tax return. This is very tax inefficient and expensive after adding in the additional hidden fees in mutual funds. Additionally, there could also be management fees paid to a financial advisor. Once adding up the expense ratio fee, turnover rate fee, tax inefficiencies and management fees, the client may be paying in excess of 2%-3%+ a year and not even be aware of the high costs since fees in mutual funds are buried in the funds published gain/loss for the period.
As a CPA & CFP fee only advisor, all my portfolios are managed for both tax efficiency and fees. Since I invest in individual stocks, individual bonds and a handful of ETFs, the internal fees associated with these investments are very low (only ETFs have an expense ratio of approximately .30% representing about 1/3 of a portfolio). After accounting for my management fee and the fees in ETFs, my fees are often less than what a prospective client is paying. Further, I pay special attention to tax allocation so to minimize the taxation of the investments. For example, if a client has both taxable and retirement accounts and is in a high tax bracket, then most dividend paying stocks and corporate bonds will be allocated to retirement accounts with non dividend paying stocks and municipal (tax free) bonds allocated to taxable accounts. This generates what is referred to as "tax alpha". The additional return generated by avoiding unnecessary taxes on the investments themselves.
Allocation of investments in accounts, generating tax alpha and finding the hidden fees is a complicated process but can be quite beneficial in optimizing your portfolio returns over time.