Morningstar Advisor - Fall 2008 - 42

Spotlight varies from year to year, whenever that client is in a “lower bracket” year, pay as much tax as possible without crossing into the next bracket. And liquidity needs are often more important than the optimal location. In theory— from an asset-location standpoint—it might make sense to keep cash reserves in a tax-deferred account. But the penalty charges associated with an early withdrawal from a tax-sheltered account would no doubt be greater than any tax savings enjoyed. There’s also the issue of losses. While most examples are built around minimizing the taxes on gains, as the recent market performance has made clear, losses are very real. And one way to minimize taxes is careful harvesting of losses to offset realized gains. Holding a security in a tax-deferred account erases the ability to realize tax-deductible losses. As the more volatile asset class, stocks are more likely than bonds to generate losses. Fortunately, the standard basic approach to asset location keeps stock investments in the taxable world, allowing for realized losses. Looking Forward from their oil and gas stocks, says, “If Obama is elected, we’ll probably harvest them all.” Plant cautions that if rates are raised in 2009, it’s likely that the rate change will be retroactive to the first of the year. “If Obama wins, there’ll be some selling before the end of 2008,” he says. If marginal rates and capital gains rates converge, the added value of asset location will diminish. However, the strategy of delaying the payment of taxes for interest income until the client is in a lower tax bracket (via sheltering that income within a tax-deferred account) remains sound. And if marginal rates are increased for the top brackets, advisors will have even more opportunities to add value via proper asset location—and the risks of location mistakes will be even greater. K David Harrell is a contributing editor. This article was written before Election Day, but as we discussed in the first article of this section, tax rates at best are staying the same, though they appear more likely to go up. Harroz and Plant believe that it’s likely that the next president—whether it’s John McCain or Barack Obama—will end the preferential treatment of capital gains and dividends. If those rates aren’t raised across the board, they may be means tested, which would affect a high-net-worth client base the most. Indeed, Plant, who is already harvesting the recent gains that some clients have seen How Taxes Erode Returns Over the long run, the adverse effect of taxes on returns becomes pronounced. Stocks are the only asset class depicted that provided any significant longterm growth. After considering taxes, government bonds barely outperformed Stocks $10,000 1,000 100 10 1926 1935 1945 1955 1965 1975 1985 Inﬂation 1995 2005 $3,246.39 $644.22 inflation. Municipal bonds (for which income is exempt from federal income taxes) outperformed government bonds but significantly underperformed stocks. Government Bonds $10,000 1,000 100 10 1926 1935 1945 1955 1965 1975 1985 Inﬂation 1995 2005 $78.78 $16.33 $11.72 $11.72 Compounded Annual Return: Before Taxes: 10.4% After Taxes: 8.2% Compounded Annual Return: Before Taxes: 5.5% After Taxes:3.5% Municipal Bonds $10,000 1,000 100 10 1926 1935 1945 1955 1965 1975 1985 Inﬂation 1995 2005 $33.48 $11.72 Treasury Bills $10,000 1,000 100 10 1926 1935 1945 1955 1965 1975 1985 Inﬂation 1995 $20.19 $11.72 $6.43 2005 Compounded Annual Return: Before and After Taxes: 4.4% Compounded Annual Return: Before Taxes: 3.7% After Taxes: 2.3% 42 Morningstar Advisor Fall 2008

Morningstar Advisor - Fall 2008

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