Approaching Zero Taxes - Savant Capital · Approaching Zero Taxes GO A L: CO M P L E T E L YEL I M I N A T ETA X 1 Approaching Zero Taxes - Savant 12/17/03 9:04 AM Page 3 “Active”

Savant Capital Management

Approaching Zero Taxes

Investment Tax Tools to Maximize After-Tax Wealth

Tadvisory firm based in Rockford, Illinois. Savant manages approximately half a billion dollars in assets for financially

established individuals, trust funds, retirement plans, non-profit organizations, and fiduciaries. Furthermore Savant

is part of the Zero Alpha Group, LLC, an industry group sharing common investment and planning philosophies. Zero Alpha

Group currently manages in excess of 3 billion dollars. We owe a particular debt of gratitude to Pat Beaird and Steve Lugar of

BHCO Capital Management, Inc., a Zero Alpha Group member firm in Dallas, Texas. Pat and Steve each offered thought-

ful editorial and technical review. • Savant has regularly been recognized among the top wealth managers in the United States

by Bloomberg, one of the most respected firms in finance. Savant has further been recognized as one of the nation’s top 250

financial advisors by W o r t h magazine each year since 1997. In 2003, Savant was included in The Wealth Factor, a book profiling

ten of the most innovative and respected wealth management firms in the nation.

Thomas A. MuldowneyMSFS, ChFC, CLU, C FP®, CRC

Tom is a Managing Director, portfoliomanager and financial advisor withSavant. He has 29 years of experience inthe financial services industry. Prior tofounding Savant, Tom worked in theinsurance, brokerage and banking indus-tries. Tom teaches courses for RockValley College and is a frequent speakerfor corporations and other groups.

Tom holds a BA from Rockford Collegeand a Masters in Financial Services(MSFS) from the American College. Heis a Chartered Life Underwriter (CLU),Chartered Financial Consultant(ChFC), Certified RetirementCounselor (CRC) and CertifiedFinancial PlannerT M (C FP®).

Tom is a member of many professionalorganizations including: NorthernIllinois Estate Planning Council BoardMember, National Association ofPersonal Financial Advisors (NAPFA),the Financial Planning Association,Society of Financial Service Professionals,The Strategic CoachTM and Legatus.

Richard A. BennettCFSC

Dick is a Principal, financial advisor, andemployee benefits specialist with Savant.He has nearly 17 years of experience as atrust officer and financial advisor. Priorto joining Savant, Dick was the RegionalDirector of Trust and Senior VicePresident for Mercantile Bank. He wasresponsible for supervising client invest-ment portfolios and managing a 350million dollar trust department.

Dick holds a BS in BusinessAdministration from Eastern IllinoisUniversity. He has a Certified FinancialCounselor Designation (CFSC) andreceived extensive training at the ABANational Trust and Graduate TrustSchool. He attended the McKay BarlowCompany Retirement TrainingProgram and is also a graduate of theFreeport Leadership Institute. He iscurrently completing the CertifiedFinancial PlannerT M (C FP ®)D e s i g n a t i o n .

Brent R. BrodeskiMBA, CPA, CFP®, CFA

Brent is a Managing Director, portfoliomanager and a financial advisor withSavant. He has more than 14 years ofexperience in the financial servicesindustry. He currently or has previouslytaught investment and finance courses atRock Valley College, Rockford College,and Northern Illinois University.

Brent holds a BS in Finance andEconomics and an MBA, with anemphasis in Accounting, from NorthernIllinois University. He is a CertifiedPublic Accountant (CPA), CertifiedFinancial PlannerTM ( C FP®), and aChartered Financial Analyst (CFA).

Brent was formerly the president of theIllinois CPA Society and a Board mem-ber of the Northern Illinois EstatePlanning Council. He has been a long-term participant in The StrategicCoachTM and currently belongs to a TECgroup. Since 1997, Brent has been listedas one of Worth Magazine’s “Nation’sTop Financial Advisors”. He has alsobeen named by J.K Lasser’s as one of thenation’s top professional advisors.

his position paper was written and edited by Savant Capital Management, a fee-only investment and financial

© Copyright 2003, Savant Capital Management. All rights reserved.

Albert Einstein once noted, “The hardest thing in the

world to understand is the income tax.” We concur.

Since Congress fatefully ratified the sixteenth

amendment in 1913 legalizing the income tax, entire indus-

tries and professions have been born to eliminate and defer

tax. This is reasonable and fair. As Judge Learned Hand so

eloquently put it, “Over and over again, courts have said

there is nothing sinister in arranging one’s affairs to keep

taxes as low as possible. Everyone does, rich or poor; and all

do right, for nobody owes any public duty to pay more than

the law demands.” While these words resound with common

sense, the investment industry largely ignores the idea. Even

worse, most conventional wisdom regarding tax-efficient

investing is misdirected, antiquated, or simply wrong!

In their seminal paper on the impact of taxes on investing,

Arnott and Jeffery said, “Taxes matter a lot.” They demon-

strated that taxes are one of the single largest and most con-

trollable costs of investing. While ignoring taxes was easy in

the double-digit return era of the 1990s, reducing taxes in

today’s lower return environment is more important than

ever. A recent study 1 confirmed this. Amazingly, over 30

years, the average mutual fund investor lost a whopping 58%

of their cumulative return to taxes. While a $1 investment

grew to $21.89 for a tax-free investor, the taxable investor

with identical holdings accumulated only $9.87.

While the goal of completely eliminating taxes is worth

striving for, its pursuit leads many astray. Driven by this goal,

too many people make ill-conceived decisions that result in

poor returns, or even worse, loss of principal. The more opti-

mal goal is to maximize your after-tax rate of return. In other

words, “Having the tax tail wag the dog is not a good thing,

but neither is ignoring the tail.” 2

This paper explores a relatively new approach to

investing known as “Tax-efficient investing.” In the past,

the investment industry and academia have largely ignored

tax implications and instead focused strictly on risk and

return. Tax-efficient investing adds tax ramifications as

the critical third leg to the investment management stool

( r i s k / r e t u r n / t a x e s ) . This is a complex concept. Tax-efficient

investing deals with constantly changing tax laws, multiple

types and rates of tax, the continual battle between tax strate-

gists and fickle politicians, and the added complexity of state

and local taxes. We suspect it is both this complexity and

inherent conflicts of interest that have led the industry to

largely ignore taxes. We will introduce a suite of investment

tax tools that can be used to form a Tax-efficient investment

approach, with the ultimate goal of increasing after-tax

returns. We can’t overstate the importance of after-tax

returns. As legendary investor Sir John Templeton said, “ F o r

all long-term investors, there is only one objective—max-

imum total return after taxes.” We couldn’t agree more!

The scope of this paper is limited to tax tools and strate-

gies applicable to existing portfolios. We do not cover tax

strategies for accumulating and saving money, consuming

portfolio assets or avoiding estate taxes. 3 We also make some

important simplifying assumptions (see references and

m e t h o d o l o g y ). 4 Of critical importance, this paper incorpo-

rates the tax law changes legislated in the recent Jobs and

Growth Tax Relief Reconciliation Act of 2003.

Approaching Zero Taxes

GO A L: CO M P L E T E L Y EL I M I N A T E TA X

1

Approaching Zero Taxes - Savant 12/17/03 9:04 AM Page 3

“Active” Investment Management Results in Excessive Tax

In his classic book, A Random Walk Down Wall Street, 5

Burton G. Malkiel suggested, “Investors should be wary

of any scheme that promises unusually large returns

based on past patterns. Relative to a buy-and-hold strategy,

the only beneficiaries are likely to be your broker and tax col-

lector.” This statement fairly summarizes the challenges that

active managers face in taxable investing. As difficult as it is

to outperform the market before taxes, it’s nearly impossible

after taxes. Even the SEC recognizes this. They now require

mutual funds to report after-tax returns. Unfortunately, this

disclosure is made in the fund prospectus, which is usually so

complex that few investors even attempt to read it.

In their quest to “beat the market” via speculation and

superior stock picking, active managers face an uphill battle.

In practice, active investors and traders need to overcome

three burdens compared to passive investors: higher

expenses, higher trading costs, and a higher tax burden.

Trading costs include commissions as well as the potentially

more significant bid-ask spread and market impact.” 6 W h i l e

the challenges of high costs are well documented, few

people in the money management business understand

that the tax cost of trading is just as important. In fact, it

may be the single most important expense item.

The problem is that routine securities trading by the a c t i v e

manager makes it almost impossible for investors to defer taxes.

It triggers the recognition of expensive short-term capital gains

(taxed at up to 35%). Unfortunately, this problem cannot be

eliminated. Active managers are in the business of selling

alpha—a measure of above market performance—which is then

reduced by taxes. Brokers are compensated by commissions on

the trades that generate the taxes, so there is little incentive on

the “sell side” of Wall Street to highlight tax considerations. 7

Figure 1 illustrates the tax and expense drag imposed by

active management. Jeffery and Arnott noted, “Passive index-

ing is a very difficult strategy to beat on an after-tax basis,

and therefore, active taxable strategies should always be

benchmarked against the after-tax performance of an indexed

a l t e r n a t i v e .” 8 Accordingly, our analysis 9 compares after-tax

expected returns for actively managed investment strate-

gies—ranging from low turnover to high turnover—to a buy-

and-hold, tax-efficient index strategy 1 0. Based on estimated 1 1

(gross) equity returns of 10.2% per year for actively managed

and index funds alike, and based on current dividend yields,

tax rates and expenses, the index investor is expected to lose

1.06% per year (10.20% – 9.14%) to mostly “unavoidable”

tax and expense. In contrast, actively managed strategies are

expected to lose up to 5.8% of their return to tax and

expense. Even low turnover active strategies add considerable

“avoidable cost.”

To be fair, the above analysis assumes that active managers

earn market returns before expense. In the aggregate, this must

be true 1 2. Still, some managers actually “beat the market.” The

problem is, after tax and expenses, even skilled managers must

beat the market by huge margins to add value. Figure 2 illus-

trates this challenge. Average and high turnover managers must

beat the market by 3.72% and 7.29% annually just to match

the after-tax return of a tax-efficient index fund.1 3

The implications are obvious. One study 8 showed that while

21% of active managers beat the market, fewer than 7% did so

after taxes. Another study1 4 found the top 8% of managers beat

the market by an average of 1.4% per year, after taxes.

However, the worst 8% of managers failed by 9.7% per year.

Active management hardly seems worth the risk!

2


Expected Annualized After-Tax Returns of Various Equity Fund Strategies 9, 10

(Assumes a 20-year holding period with liquidation at end.)

Pre-Tax Active Management Returns Required toBeat a Buy-and-Hold Index Fund Strategy 1 3


Figure 1

Figure 2

3

AVOIDABLE TAX AND EXPENSE

EXCESS RETURN (ALPHA) NEEDED TOBEAT INDEX RETURNS AFTER TAX

P r e - T a xE s t i m a t e d

Equity Returns*

T a x - M a n a g ed 13

Index or ETF*Low Turnover 13

Active (25%)Typical Turnover 13

Active (100%)High Turnover 13

Active (200%)

Tax-ManagedEquity Index or

ETF (After-Tax) 10

Low TurnoverActive (25%)( A f t e r - T a x) 9

T y p i c a lT u r n o v e r

Active (100%)( A f t e r - T a x)9

High TurnoverActive (200%)

( A f t e r - T a x) 9

4 . 4 0 %

6 . 1 6 %

7 . 5 4 %

9 . 1 4 %

1 0 . 2 0 % *

1 0 . 2 0 % *

9 . 1 4 % 9 . 1 4 % 9 . 1 4 % 9 . 1 4 %

1 1 . 9 2 %

1 . 7 2 %

1 3 . 9 2 %

3 . 7 2 %

1 7 . 4 9 %

7 . 2 9 %

Gross Pre-Tax Return

After-Tax Return

*10.20% Gross pre-tax return based on S&P 500 from 1926 – 2002.

*10.20% Pre-tax estimated equity return based on S&P 500 from 1926 – 2002.


4

The High Costs & Negative Tax Implications ofVariable Annuities Consumes Investor’s Wealth(Assumes a 20-year holding period with liquidation at end.)

State Sponsored Section 529 College Savings Plansare Not Always the Best Way to Save for College 1 8



ETF (After-Tax) 10

Lowest CostV a r i a b l eA n n u i t y

( A f t e r - T a x) 1 6

Lowest CostV a r i a b l eA n n u i t y

(After-Tax) (Pre 591⁄2) 1 6

Average CostV a r i a b l eA n n u i t y

( A f t e r - T a x)1 6

Average CostV a r i a b l eA n n u i t y

(After-Tax) (Pre 591⁄2) 1 6

5 . 6 2 %6 . 2 3 %

7 . 1 1 %7 . 8 0 %

9 . 1 4 %

1 0 . 2 0 % *

Figure 3

Figure 4

AVOIDABLE TAX AND EXPENSE


ETF (After-Tax) 10

Gifting of T.M. Index or ETF at

College Age 1 8

Gifting ofT.M. Indexor ETF toU G MA 1 8

Low Cost §529 Plan( Q u a l i f i e d

D i s t r i b u t i o n) 1 8

Low Cost §529 Plan

( N o n - Q u a l i f i e dD i s t r i b u t i o n) 1 8

6 . 9 9 %

9 . 5 5 %9 . 5 7 %9 . 1 4 %

1 0 . 2 0 % *

LOST TO TAXES

AND EXPENSE

9 . 7 2 %


Equity Returns*



Equity Returns*



Having already referenced the admonition, “Don’t

let the tax tail wag the dog,” let’s explore how

investors fall prey to this possibility in the real

world. Sadly, it is the investors’ disdain for paying taxes that

frequently leads them astray. Too often, they pursue high

risk schemes or purchase marginal products from oppor-

tunistic salespeople who happily prey on their contempt for

paying tax. The products they peddle are often misdirected,

based on antiquated laws, fail to survive IRS scrutiny or are

simply inappropriate. While the investor may pay less tax, it

often comes at the cost of lower returns.

The seventeenth century French politician Jean Baptiste

Colbert once said, “The art of taxation consists in so plucking

the goose as to get the most feathers with the least hissing.”

Likewise, the art of designing tax-avoidance products is to

opportunistically press a prospective investor’s tax “hot-

buttons” to justify inordinate fees without notice. H i s t o r y

offers many examples. They include oil and real estate limited

partnerships, life insurance schemes, principal-protected

funds and exotic derivatives strategies. The dollars lost in

these flawed products often end up serving as expensive

“ t u i t i o n . ”

For example, popular variable annuity contracts issued

by insurance companies are often flawed from a tax per-

spective, yet they are sold on the premise of being tax

f a v o r a b l e . Money is invested in mutual fund-like “separate

accounts” which are owned inside of annuity wrappers.

Salespeople aggressively promote the fact that annuity con-

tracts defer tax on interest, dividends and capital gains. As

always, the devil is in the details.

Variable annuities come with a number of fatal flaws.

First, they are expensive. In addition to the typical trading

costs incurred by most stock mutual funds, annuities are

often accompanied by very high internal fees. Likewise,

annuity commissions and surrender fees are often quite large.

Second, in the long-term, annuities are “tax-nasty.” Though

they feel good along the way, annuities effectively convert

long-term capital gains (taxed at rates of up to 15%) 1 5 i n t o

ordinary income (taxed at higher rates of up to 35%).

Figure 3 illustrates the 20-year impact of taxes and costs

on variable annuities. 1 6 Each example assumes estimated 1 1

(gross) equity returns of 10.2% per year and current dividend

yields, tax rates and expenses. Note that the index fund

owned outside of a variable annuity performs better than the

same fund that’s owned inside of the more costly variable

annuity wrapper. In fact, in light of the recent tax law

changes, it is now mathematically impossible for investors to

overcome the high costs and negative long-term tax implica-

tions of a typical variable annuity. 1 7

State-sponsored §529 college savings plans are another

popular tax-avoidance product. As Figure 4 shows, these

plans lost much of their appeal with the recent tax law

changes of 2003. 1 8 While optimal use of low cost §529 plans 1 9

may deliver slightly more return than outright index invest-

ing, gifting strategies using traditional index funds may offer

even higher returns. 1 8 Also, if §529s are used for non-educa-

tional purposes (non-qualified distribution), their after-tax

returns plummet. Section §529 plans were previously too

good to be true. Now they are merely interesting.

The bottom line: investors should avoid investment

products whose advantage or investment merit is contingent

on an effective lobby (i.e. by the insurance companies).

Investors usually fare best by following sound investment

strategies that are not easily sabotaged by politicians.

Conventional Tax-Avoidance ProductsSabotage Unwary Investors

5


Many or even most conventional “tax-avoidance”

products and strategies are not conducive to

one’s financial health. With that being the case,

what is the best way to protect yourself from tax-hungry

politicians who want to get their hands on your money? First,

you need to concede that tax laws continually change. Fickle

politicians are influenced by public opinion, which is fluid

and constantly changing. They react by constantly passing

new tax laws. Art Buchwald, the newspaper columnist, wit-

tingly wrote, “Tax reform is when you take taxes off things

that have been taxed in the past and put taxes on things

that haven’t been taxed before.”

To appreciate the ever-changing tax law, simply glance

at history. Prior to 1913, the Federal income tax was uncon-

stitutional. When politicians fixed that, the floodgates burst

open! Figure 5 illustrates the, until recently, mostly upward

“tax rate roller coaster.” Initially, the highest tax rate was

only 7%, but by 1944, high-income earners were losing

94% to tax. Years later, while making his case for tax

reform, then President Ronald Reagan explained how, dur-

ing his Hollywood days, he refused to make more than one

movie per year. If he worked any harder, he kept only 10%

of the spoils.

The good news is that tax rates have returned to rational

levels. The recent 2003 tax cuts reduced ordinary income tax

rates to a maximum of 35%. This applies to earned income

as well as interest income. Capital gains and dividends now

face a top rate of 15%—their lowest rates since 1933 and

1916, respectively. Where will rates go next? The answer

probably depends on our next president.

The secret to tax-efficient investing is having a dynam-

ic and systematic process to structure your portfolio for

maximum tax efficiency. It must recognize that today’s

tax situation will probably be different tomorrow. You

must constantly adjust your tactics to new realities. The

process involves optimizing a suite of tax tools to take

advantage of current and future tax benefits.

In developing this process and suite of tax tools, investors

need to understand that there are three primary investment

strategies to reduce or eliminate tax. They include 1) perma-

nent elimination of taxes, 2) deferral of taxes into future

years, and 3) deliberately timing the recognition of income to

low rate years. As Figure 6 illustrates, all tax reduction strate-

gies leverage these three methods. For example, the primary

strategy used by tax-managed index funds and exchange trad-

ed funds (“ETFs”) is deferring tax. This also allows investors

to convert short-term capital gains into lower rate long-term

capital gains. In addition, tax deferral creates the opportuni-

ty to time the recognition of income into lower tax rate years.

In the event that an investor died prior to the recognition of

any unrealized gains, there is also a distinct possibility of per-

manently eliminating capital gains tax (see the step-up in

basis discussion on pages 20-21).

An effective, tax-efficient investment process requires

continual monitoring of one’s portfolio strategy to maximize

after-tax returns. The suite of investment tax tools must con-

tinually evolve. While it is challenging to predict which

politician will win the next tax battle, you are best served by

using current tax rules—knowing that you may have to re-

engineer and update your process every time Congress meets.

Legitimate Tax ReductionHarnesses Three Key Strategies

6


7

Figure 5

Figure 6

1 P e r m a n e n t l yEliminate Tax

2 Defer Taxes

3 Time Tax in LowRate Years

TAX STRATEGY

PRIMARY STRATEGY SECONDARY STRATEGY!! ! NOT APPLICABLE

T a x -M a n a g e dIndex or

E T F

Core a n d

S t r u c t u r e dS a t e l l i t eTM 2 0

I R A ’ sA n n u i t y

and 4 0 1 ( k )

S e c t i o n§529 P l a n s

R o t hI R A s

T a xE n g i n e e r i n g

T a xL o s s

H a r v e s t i n g

T a x - F r e eM u n i c i p a l

B o n d s

Step-Up in

B a s i s

H I F OA c c o u n t i n g

C h a r i t a b l eS t r a t e g i e s

Politicians Are Fickle:Tax Rates and Rules Change Continually

Legitimate Investment Tax ToolsLeverage 3 Key Tax Reduction Strategies

1 0 0 %

9 0 %

8 0 %

7 0 %

6 0 %

5 0 %

4 0 %

3 0 %

2 0 %

1 0 %

0 %1 9 1 3 1 9 3 0 1 9 4 0 1 9 5 0 1 9 6 0 1 9 7 0 1 9 8 0 1 9 9 0 2 0 0 3 *

Maximum Income, Dividend* &

Interest Tax Rate

Maximum Long-Term

Capital Gains Tax Rate

Current Maximum2003 Tax Rates

3 5 %Ordinary Incomeand Interest

15% Long-Term CapitalGain and Dividend*

*2003 is first year dividends and interest income rates were different. Prior to the recent 2003 tax legislation dividends were

taxed at the same rate as income and interest income.

!

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8

Large Growth Stocks are Inherently Tax-Efficient for Buy-and-Hold Investors

“Core and Structured SatelliteT M” 2 0 A p p r o a c h

Figure 7

Figure 8

– Modest turnover ascompanies becomegrowth stocks

– Higher dividends

– Very low turnover

– Low dividends

– High forced turnover ascompanies grow and/orbecome growth stocks

– Higher dividends

– Forced turnover ascompanies grow inv a l u e

– Low dividends

LARGE STOCKS

GROWTH STOCKS VALUE STOCKSLOW TAX

Most Tax-Efficient

SMALL STOCKS

Equity REITS

T a x - M a n a g e dEmerging Markets

I n t e r n a t i o n a lL a r g e

T a x - M a n a g e dU.S. Large

V a l u e

T a x - M a n a g e dI n t e r n a t i o n a l

V a l u e

T a x - M a n a g e dU.S. Small

V a l u e

I n t ern a t i o n a lS m a l l

T a x - M a n a g e dU.S. Small and

Micro Cap

V a l u eS t o c k s

G r o w t hS t o c k s

D o m e s t i c“ C O R E ”

Least Tax-Efficient

HIGH TAX

M i d c a p

M i c r o C a p

S m a l l

M i d c a p

M i c r o C a p

S m a l l

L a r g eL a r g e

Note: All vehicles outside of Domestic Core are considered Structured SatellitesT M


If traditional active management is tax-nasty and if tradi-

tional tax avoidance products are ineffective, how do you

minimize taxes? Tax-efficient investing focuses on port-

folio structure as well as low turnover, broad diversification

and adherence to a long-term buy and hold strategy.

Previously we compared active management to index

funds. As discussed, index funds provide the optimal way of

maximizing after-tax asset growth. Jonathan Clements, the

popular Wall Street Journal columnist, wrote, “If index funds

look great before taxes, their performance is almost unbeat-

able after taxes, thanks to their low turnover and thus slow

realization of capital gains.”

What is an index fund? It is a mutual fund that buys all or

most of the securities in a given asset class. For example, a

large stock index fund might purchase all the stocks traded

on domestic stock exchanges with a market capitalization

above a certain size. Index funds are available for every asset

class imaginable. Examples include large, small, growth,

value, foreign, bond, and REIT funds.

While index funds are inherently tax efficient, some index

strategies are more efficient than others. Figure 7 depicts dif-

ferent levels of tax efficiency for a variety of stock index

funds. Small value stocks tend to be the least tax-efficient. As

small value stocks “graduate,” they become either large com-

pany stocks or growth stocks and are sold from the small

value index fund, thus causing the recognition of capital

gains. Furthermore, value stocks pay higher taxable dividends

than growth stocks. In contrast, large growth stocks are very

tax efficient. Since it is impossible to graduate from being a

large growth stock, they are rarely sold (and taxable gains go

unrealized). They also pay low dividends. Most of their

return comes in the form of unrealized appreciation in value,

which is tax-deferred until the shares are sold.

Figure 8 depicts the “core and Structured Satellite” 2 0

approach to investing. This is a proprietary term that is

used to describe our diversified asset class investing. Tax

wise, the “ideal” core fund is a market-wide index fund such

as the Wilshire 5000, Russell 3000 or Dow Jones Total Stock

Market index. Capitalization weighted index funds based on

these indices are core holdings that invest in most publicly

traded stocks.2 1 This “core” holding offers three inherent

advantages: First, it is simple, broadly diverse and reflects

the consensus view of most market participants. Second, the

funds automatically remain in perfect alignment with the

market and require little or no rebalancing. Third, the buy

and indefinite hold strategy avoids realizing most gains—

even on small and value stocks.

Some people assume that investing in such a broad mar-

ket index is sufficient. However, the market’s extreme bias

toward large growth (the largest and most expensive stocks

dominate the market) exposes such investors to a high degree

of speculative risk. For example, from the market peak in

March of 2000 until the market bottom in 2003, market

wide funds lost approximately 50% of their value.

The “Structured Satellite” investments (small, value,

international, etc.) provide a high degree of diversification

from the large growth bias that is present in the core.

Around the tax-efficient core, these “Structured Satellite”

funds provide exposure to under-represented asset classes such

as micro cap stocks, small value stocks and large value stocks. 2 2

Core and Structured SatelliteT M

Portfolio Design is Tax Optimal

9


Many investors mistakenly assume that owning

mutual funds results in higher taxes. This is a

myth. While it is true that most actively man-

aged funds, and even some index funds, frequently trigger

unnecessary tax, most index and exchange traded funds

(ETFs) are extremely tax efficient. In particular, tax-managed

index funds avoid many of the common tax traps associated

with traditional funds while taking advantage of the estab-

lished tax law to accomplish optimal tax efficiency.

While tax-managed index funds avoid stock picking and

speculation, they differ from traditional index funds that

invest in exact alignment with an underlying benchmark. In

contrast, tax-managed funds only attempt to approximate a

benchmark—occasionally breaking the rules. Though this

means the fund will not perfectly track an index (it will vary

slightly plus or minus over time), this approach increases

after-tax returns. Furthermore, it does so with high certainty

and minimal cost. Unlike “active” stock picking, where the

odds of failure are high, “active tax-management” offers very

high odds for increasing returns. Ironically, for taxable

investors, ignoring tax-management may be just as irrespon-

sible as “active” stock picking.

Figure 9 illustrates six techniques that tax-managed index

funds use to maximize tax efficiency. An example illustrates

the concept. Without tax management, micro cap indexes

tend to be relatively tax-nasty. Since they represent only

about 5% of the entire value of the stock market, each year

the most successful micro cap stocks “graduate” to become

small or mid cap stocks. Without tax management, these

stocks are sold and the investors must realize capital gains.

The first strategy expands the fund’s target capitalization

range to include both micro and small cap stocks. This allows

the fund to avoid taxable sales as micro cap stocks graduate

into the small cap range. Imagine, however, that the stocks

keep growing. Employing a “hold” range to allow some

“graduation” into mid cap stocks further defers recognition

of gains. If stocks later graduate from the “hold” range, the

tax-managed fund then sells such stocks, but only after they

have been held for 12 months, thus qualifying for long-term

rates (15%) instead of short-term rates (35%). Recent tax law

changes make this particularly important. At the same time

this gain is realized, the fund may harvest other losses (see

pages 16-17) while carefully avoiding the 30-day wash sale

rule. The losses conveniently offset the gains. Tax-managed

funds also employ tax-smart techniques like HIFO account-

ing (see pages 16-17) and imposing surrender fees on short-

term traders.

While the technical nature of exchange traded funds

(ETFs) is well beyond the scope of this paper, these index

funds, which trade like stocks, are inherently tax efficient.

Investors buy ETFs through intermediary market makers. A

creation/redemption process 2 3 allows the ETF fund company

to wash out low basis stock to the market maker without

causing detriment to fund owners. This helps avoid realizing

gains. Figure 10 illustrates this complex process.

Tax-management techniques defer taxes to the future.

Deferring tax is like getting an interest-free loan from the

government to be repaid at your option—generally when

you are in a lower tax bracket. Though tax-management

techniques may slightly increase costs and portfolio turnover,

and introduce tracking error, they increase after-tax returns

by significantly more than they increase costs.

Tax-Managed Index and ExchangeTraded Funds are Tax-Efficient

1 0


1 1

Tax-Managed Index Fund Figure 9

Exchange Traded Index Fund (ETF)Tax-Efficient Creation/Redemption Process Figure 10

LARGE STOCKS

(Sell Range)

Universe of 8,459 3 6

Publicly Traded Stocks

MID-CAP STOCKS

Sell only after 12m o n t h s

Hold Range

x SMALL STOCKS

MICRO CAP STOCKS Harvest L o s s

(Expanded buy Range)

Six Tax-ManagementT e c h n i q u e s

1) Expand capitalization range

2) Employ “hold” range

3 ) Convert short-term gains to long-term by holding more than 12 months

4 ) Harvest losses to offset Capital Gains

5 ) HIFO Accounting Method

6 ) Penalty/transaction fees to discourage short-term trading

E T F MARKET MAKER(Absorbs Most Capital Gain)I N V E S T O R

( B u y e r )

E T F FUND COMPANY(Passes Most Capital Gains

to Market Maker)

C A S H C A S H

E T F S H A R E S

E T FS H A R E SC R E A T E D

H I G HB A S I S

S E C U R I T I E S

L O WB A S I SS E C U R I T I E S

E T FS H A R E S

R E D E E M E D

S E C U R I T I E S

CAPITAL M A R K E T S


1 2

Investor Tax Buckets are Taxed at MultipleTax Rates, Currently and in the Future

M a x i m u m M a x i m u m Retirement RateTYPE OF GAIN Current Tax Rate Future Tax Rate (if below max)

Interest and NQ Dividend N / A 35 % 10 – 33 %

Short-Term Capital Gain N / A 3 5 10 – 33

Qualified Dividend N / A 3 5 10 – 33

Long-Term Capital Gain N / A 3 5 10 – 33

IRD (Income Tax at Death) N / A 3 5 10 – 33

Figure 11


Interest and NQ Dividend 35 % N / A N / A

Short-Term Capital Gain N / A 35 % 10 – 33 %

Qualified Dividend 1 5 N / A N / A

Long-Term Capital Gain N / A 1 5 0 – 5

IRD (Income Tax at Death) N / A 0 0


Interest and NQ Dividend 0 % 0 % 0 %

Short-Term Capital Gain 0 0 0

Qualified Dividend 0 0 0

Long-Term Capital Gain 0 0 0

IRD (Income Tax at Death) 0 0 0

Tax-Deferred T a x a b l e Roth IRATYPE OF INVESTMENT A c c o u n t s A c c o u n t s A c c o u n t s

TAX-NASTY STOCKS (High Dividend, High Realized Gain) B E T T ER 3 5 B A D B E ST 3 5

TAX-EFFICIENT STOCKS (Low Dividend, Low Realized Gain) B A D B E S T B E T T E R

TAXABLE BONDS (Government, Agency, Corporate) B E S T B A D F A I R

TAX-FREE BONDS ( M u n i c i p a l ) VERY BAD V A R I E S*3 4 VERY BAD

C A S H (Money Market, T-Bills, Savings, CDs) B E T T E R B E T T E R B A D

Note: Ideal asset locations are in bold.

T A X - D E F E R R E DA C C O U N T S

(IRA, 401k, 403b,Annuity, Pension)

T A X A B L EA C C O U N T S

ROTH IRAA C C O U N T


In the quest for maximum tax-efficiency, asset location is

nearly as important as the actual investments you make.

To understand, imagine that you hold your portfolio in

three different tax buckets (which are discussed below). The

buckets catch and hold your growth. Still, some gains evapo-

rate due to taxes, depending upon which bucket your money

is in. This “tax bucket” analogy simplifies the myriad of tax

rates, regulations, rules and types of income.

The three most common tax buckets include 1) tax-deferred

accounts (i.e. traditional IRA, 401k, 403b, annuity and pension

assets), 2) taxable accounts and 3) Roth IRA accounts. By

happenstance, some people have all their assets in one bucket,

although most investors have them spread over two or more

buckets. The Roth IRA bucket is often the smallest (since

this is a newer type account) while taxable and tax-deferred

buckets are typically largest.

Understanding how, when and at what rates your invest-

ments are taxed is essential in deciding which investment you

should hold in which bucket. The implications of investing

in various “tax buckets” are illustrated on the previous page.

Investors love the Roth IRA bucket and the tax-deferred

bucket. The Roth investor generally avoids all taxes—cur-

rently and in the future. Tax-deferred investors defer all taxes

to the future. However, this deferral comes at a cost. When

the money is withdrawn, all gains—even capital gains—are

taxed as ordinary income at rates up to 35%. Lower capital

gain rates do not apply. Tax-deferred investors likewise miss

an opportunity to receive a step-up in basis (see pages 20-21).

At death, the investors’ estate or heirs always get taxed on the

accumulated gains inside of tax deferred accounts.

Taxable accounts are more complex. Dividends are now

taxed (in the year received) at rates up to 15%. Non-qualified

dividends and interest currently get taxed at rates up to 35%. By

design, capital gains—both short-term (held less than 12

months) and long-term (held 12 months or more)—are taxed in

the future, when shares are sold. Short-term gains are taxed at up

to 35% while long-term capital gains can be deferred for a long

time and are ultimately taxed at rates no higher than 15%. As

discussed on pages 20-21, the step-up in basis that occurs at

death may result in the permanent elimination of capital gains.

One big advantage of deferring tax (tax-deferred and tax-

able buckets) is that rates often decline in retirement. A top

bracket taxpayer (35%) may see their tax rate decline to 25%

or less during retirement years. This can greatly reduce taxes!

Conventional wisdom is often wrong with respect to tax

bucket management (asset location). Historically, many

investors have errantly held long-term investments (stocks) in

tax-deferred accounts. Unfortunately, this eliminates the

opportunity to benefit from preferential long-term capital

gains and dividend tax rates (of only 15%). In addition, hold-

ing stocks in tax-deferred accounts prevents the investor from

engaging in loss harvesting (see pages 16-17). As Figure 11

illustrates, it makes more sense to hold most stocks in taxable

accounts. Certain “tax-nasty” stocks are better off in Roth

IRAs while corporate and government bonds are ideally

placed in tax-deferred accounts.

Most investors ignore tax consequences or don’t proper-

ly divide their investments among their accounts. Though

effective tax bucket management is counter-intuitive and

complex, the benefit of getting it right is significant.

Effective asset location does not increase your gross return

but reduces how much tax you pay on April 15t h. You earn

more by saving tax.

Proper Tax “Bucket” Structure isof Paramount Importance

1 3


Tax-Engineering is an effective method of coordinat-

ing and assembling your assets to eliminate and/or

defer unnecessary taxes. It focuses on getting the

right investments, within your asset allocation strategy, posi-

tioned in the right tax buckets (see previous page). This does

not change your actual gross return; it just systematically

reduces your tax bill and increases your after-tax return.

Tax-engineering is neither simple nor intuitive. It requires

making investment decisions on a portfolio-wide basis and is a

two-step process. First, investors must determine their overall

asset allocation. This is based on risk and return preferences.

The allocation decision determines the optimal combination

of asset classes including large stocks, small stocks, bonds, etc.

Step two then focuses on proper asset location—it determines

which investments belong in which tax buckets.

The benefit of tax-engineering is illustrated by the exam-

ple in Figure 12. We illustrate three different scenarios in

which we compare a tax-engineered portfolio to two others in

which tax assumptions were either incorrect or ignored (which

we refer to as “tax-backwards investing”). Each example

assumes an investment of 60% equity and 40% fixed income,

which is a typical retirement allocation. We assume 2/3 of the

equities are invested in a “core” market portfolio with the

remaining 1/3 in small stocks. The investor also has three

buckets—40% each in tax-deferred and taxable accounts and

20% in a Roth IRA. In all three examples, the gross expected

return before costs and taxes is 9.30%.2 4

In the first scenario, the tax-engineered index portfolio

optimally positions the market-wide fund in the taxable

bucket, small stocks (a “Structured Satellite” fund) in the

Roth bucket and bonds in the tax-deferred bucket. This tax-

efficient investor loses only 1.0% 2 5 annually to taxes. The second

scenario shows an investor with the same exact holdings, but

located in exactly the wrong buckets. This simple “location

error” causes the investor to pay an additional 1.1% 2 6 in extra

tax (7.2% net return after taxes instead of 8.3%). The third

investor is most typical. Instead of investing in index funds with

core and Structured Satellite investments, they own tax-nasty,

actively managed funds in a “tax-backwards” manner (using the

wrong buckets). Even before tax, the high costs of active man-

agement cause a significant reduction in return for this investor

(7.1% net return after costs vs. 8.9% for the index and

Structured Satellite investor).2 7 After taxes and costs, the tax-

backwards, actively managed portfolio sees its gross return of

9.3% shrink to a mere 5.6%—a total shrinkage of almost 40%.

If anything, the above examples understate the true benefits

of optimal tax-engineering. In the first scenario, losses in the

taxable bucket could be harvested to offset gains (see pages 16-

17). In contrast, the “tax-backwards” investor loses the ability

to harvest and recognize losses since you cannot deduct losses

in tax-deferred accounts.

Tax-engineering provides significant opportunities for

investors. Though effective asset location is often ignored

by many financial advisors and is contrary to conventional

financial advice, it can empower investors to proactively

organize their portfolios and earn far more than those who

ignore taxes.

Tax-Engineering may be the mostEffective Way to Reduce Tax

1 4


1 5

Tax-Engineering and Low Costs Increase Returns Over Time60/40 stock/bond portfolio, liquidation after 20 yr. holding period, no rebalancing

40% tax-deferred, 40% taxable, 20% Roth IRA assets Figure 12

TAX-ENGINEERED 60/40 USING CORE TAX-MANAGEDINDEX AND STRUCTURED SATELLITE TM 2 5

TAX-BACKWARDS 60/40 USING CORE INDEXFUND AND STRUCTURED SATELLITE TM 2 6

TAX-BACKWARDS 60/40 USING ACTIVE COREAND ACTIVE SATELLITE STRATEGIES 2 7

T a xD e f e r r e d

4 0 %

T a x a b l e4 0 %

R o t h2 0 %

20% SmallS t o c k s

40% Market Index( S t o c k s )

40% Bonds

20% SmallS t o c k s

40% Market IndexF u n d s

40% Bonds

9 . 3 % 8 . 9 % 8 . 6 %

$ 4 . 8 8

8 . 3 %

G r o s sR e t u r n(1926 –2 0 0 2) 2 5

N e tR e t u r nA f t e r

C o s ts 2 5

N e tR e t u r n

A f t e r - T a x( S t e p - U p) 2 5

Net R e t u r n

A f t e r - T a x( L i q u i d a t e)2 5

Growth of$1 After

L i q u i d a t i o nT a x e s

9 . 3 % 8 . 9 %

7 . 2 % $ 4 . 0 57 . 2 %

G r o s sR e t u r n(1926 –2 0 0 2) 2 5


C o s ts 2 5

Net R e t u r n

A f t e r - T a x( S t e p - U p) 2 6

Net R e t u r n

A f t e r - T a x( L i q u i d a t e) 2 6

Growth of$1 After


9 . 3 %

7 . 1 %

5 . 6 %5 . 6 %

G r o s sR e t u r n(1926 –2 0 0 2) 2 5


C o s ts 2 7

Net R e t u r n

A f t e r - T a x( S t e p - U p) 2 7

Net R e t u r n

A f t e r - T a x( L i q u i d a t e)2 7

Growth of$1 After


Source: Savant A n a l y s i s

$ 2 . 9 8

Constant and organizedasset allocations cannot bemaintained with ActivelyManaged Strategies.


1 6

The Arithmetic of Tax Loss HarvestingThree-year tax savings from harvesting a $25,000 loss. Figure 13

Comparing HIFO (Highest-in, First-out) toAlternative Tax Accounting Methods Figure 14

Without Loss Harvesting With Loss HarvestingY E A R A C T I V I T Y Gain (Loss) Tax Cost Gain (Loss) Tax Cost

1 Realized Short-term Gain $ 5,000 $ 1,750 $ 5,000 $ 1,750

Realized Long-term Gain 5 , 0 0 0 7 5 0 5 , 0 0 0 7 5 0

Harvest $25,000 Long-term Loss – – ( 1 3 , 0 0 0 ) * ( 3 , 5 5 0 )

2 Realized Long-term Gain 3 , 0 0 0 4 5 0 3 , 0 0 0 4 5 0

Carry Forward $12,000 Long-term Loss – – ( 6 , 0 0 0 ) ( 1 , 5 0 0 )

3 Realized Short-term Gain 1 , 0 0 0 3 5 0 1 , 0 0 0 3 5 0

Realized Long-term Gain 2 , 0 0 0 3 0 0 2 , 0 0 0 3 0 0

Carry Forward $6,000 Long-term Loss – – ( 6 , 0 0 0 ) ( 1 , 5 0 0 )

Total Tax Cost (Credit) $ 3,600 + $ (3,150)

Cumulative 3-Year Benefit $ 6,750Loss Recapture = $6,750/$25,000 = 2 7 %

Multiple Lots AccumulatedHolding C u r r e n t C o s t U n r e a l i z e dP e r i o d V a l u e B a s i s G a i n

15 mos. $ 25,000 $ 15,000 $ 10,00010 mos. 2 5 , 0 0 0 2 0 , 0 0 0 5 , 0 0 01 mo. 2 0 , 0 0 0 1 9 , 6 0 0 4 0 0

7 0 , 0 0 0 5 4 , 6 0 0 1 5 , 4 0 0

Total Taxes from $30,000 Partial Sale

Highest-in, First-out (HIFO)S h a r e s C u r r e n t

S o l d V a l u e G a i n T a x e s

1 mo. $ 20,000 $ 400 $ 14015 mos. 1 0 , 0 0 0 4 , 0 0 0 6 0 0

3 0 , 0 0 0 4 , 4 0 0 7 4 0

Average Cost Basis

S h a r e s C u r r e n tS o l d V a l u e G a i n T a x e s

15 mos. $ 10,714 $ 4,285 $ 64310 mos. 1 0 , 7 1 4 2 , 1 4 3 7 5 01 mo. 8 , 5 7 7 1 7 1 6 0

3 0 , 0 0 0 6 , 5 9 9 1 , 4 5 3

First-in, First-out (FIFO)S h a r e s C u r r e n t

S o l d V a l u e G a i n T a x e s

15 mos. $ 25,000 $ 10,000 $ 1,50010 mos. 5 , 0 0 0 1 , 0 0 0 3 5 0

3 0 , 0 0 0 1 1 , 0 0 0 1 , 8 5 0

$ 7 4 0

$ 1 4 5 3

$ 1 8 5 0

HIFO M e t h o dT a x e s

Avg. CostM e t h o dT a x e s

FIFO M e t h o dT a x e s

*Only $13,000 of the $25,000 loss can be used in year one. This equals total year one gains plus an additional $3,000 loss. Example carries forward the remainder ($25,000 – 13,000 = 12,000) to years 2 & 3. $6000 is used in both years 2 and 3.


Recognizing capital losses is never fun. While we

would prefer to never lose money, as in contests and

sporting events, you can’t win all the time. Growth

oriented investors occasionally suffer the agony of defeat.

Happily, the investment world does offer taxable investors a

consolation prize. Tax loss harvesting allows us to recapture

some of the loss from Uncle Sam.

Loss harvesting is not complex. Investors have the ability

to control the timing and recognition of gains and losses.

Successful investments can be held indefinitely—allowing

long-term deferral of gains. In contrast, it is prudent to sell

losing investments in order to get current year tax write-offs.

Importantly, this can only be done in taxable accounts (not

in tax-deferred accounts, i.e. IRAs).

Ideally, losses are harvested in a disciplined and sys-

tematic manner that continually captures tax benefits and

preserves them for current and future use. Any unused

losses can be carried forward indefinitely to offset future

g a i n s .2 8 This counter-intuitive process is mentally diffi-

cult in that it requires investors to admit their losses by

selling losers.

A typical loss harvesting transaction might involve selling

an investment with a $25,000 capital loss and concurrently

buying back a similar, but not identical investment. To avoid

IRS “wash sale rules,” you cannot repurchase the identical

security for 31 days. Nothing really changes aside from realiz-

ing a valuable tax benefit. Figure 13 illustrates that this most-

ly risk free and cost free transaction results in a $6,750 tax

reduction over three years. Without loss harvesting, other gains

result in $3,600 of additional tax. In contrast, the investor that

harvests $25,000 in losses receives a net tax reduction (refund)

of $3,150. This $6,750 difference effectively recaptures 27%

of the original $25,000 loss incurred.

While this transaction lowers tax basis (possibly creating

future gains), it also maximizes tax savings by potentially off-

setting short-term capital gains and ordinary income of up to

$3,000 per year.

At tax time, many investors err in their selection of an

accounting method for tax purposes. After selling a partial

position, the IRS offers multiple methods to determine your

tax basis in the shares sold. Most investors accumulate shares

over time and at varying prices. Thus, the wrong accounting

method may cause the investor to realize gains on highly

appreciated shares (tax lots) while holding shares with small-

er gains or possibly even losses.

To illustrate this concept, Figure 14 shows an investor

who is selling $30,000 from what was originally a $70,000

holding. The total position was accumulated in three trans-

actions—15 months, 10 months and one month ago. All

three purchases or lots have appreciated in value. The first

purchase or position should qualify for long-term gain while

the latter two lots would produce short-term gains. At the far

right, we provide the tax calculation for FIFO (first-in, first-

out), average cost (most typical method) and HIFO (highest-

in, first-out) accounting methods. HIFO is also at times

referred to as “specific lot” accounting.

As is nearly always the case, HIFO accounting results

in much lower taxes. Importantly, there is no additional

cost or risk in choosing HIFO—it is merely an account-

ing election. HIFO elections can be instrumental in maxi-

mizing loss harvesting opportunities.

Tax Loss Harvesting and HIFOAccounting Can Save Tax

1 7


When the constitution was changed in 1913 to

legalize income taxes, the prohibition against

the federal government’s taxing of state and

local governments remained intact. This provides high brack-

et investors with a valuable tax savings opportunity. While

Treasury, government agency, corporate and foreign bonds

are all taxed at ordinary rates of up to 35%; bond interest

paid by most state and local governments (municipalities) is

exempt from federal taxation.

There are many varieties of tax-free municipal bonds.

General obligation bonds are backed by an issuer’s general

taxing authority and revenue bonds are backed by revenues

generated by specific projects. Insured municipal bonds have

insurance companies who contractually assure their repay-

ment, while pre-refunded bonds are collateralized by U.S.

Treasury bonds.

While the tax-free nature of municipal bonds is appealing,

like everything in life, it comes with a price. Because of their

tax-free status, issuers of municipal bonds have a leg up on

issuers of taxable bonds. Thus, the tax-free yield they offer is

generally lower than that paid by corporations or the U.S.

Treasury. While the reduction in yield has varied over time, on

average, municipal bonds historically pay 74% to 81% of the cor-

responding yield offered by U.S. Treasuries.29 Low tax bracket

investors should generally avoid municipal bonds—irrespective

of the tax-free advantage. Even after paying taxes, low bracket

investors are usually better off buying taxable bonds. In contrast,

the yield reduction is generally well worth it for high bracket

investors (i.e. 30% tax bracket or higher).

To better understand municipal bonds, and to compare

apples to apples, the yield on tax-free muni-bonds must be

converted into a “taxable-equivalent” yield. Figure 15 calcu-

lates the break-even rate for taxable versus municipal bonds.

This point depends on your marginal tax bracket. For exam-

ple, a 3.5% tax-free municipal bond investor in the 35%

bracket would need to earn more than 5.38% in taxable

bonds to be better off. In contrast, a low bracket (10%) tax-

payer needs to earn only 3.89% to be better off in taxable

bonds. You can reference Figure 16 to determine your mar-

ginal tax bracket.

For investors in high tax states, municipal bonds issued

in your home state often make great sense because most

states do not tax municipal bond interest paid on their own

bonds. California, New York, Massachusetts, and Iowa are

good examples.

Though municipal bonds offer advantages, they are

often misused. While municipal bonds are most appro-

priate for high bracket investors, low bracket investors

often use them inappropriately and when taxable bonds

would make more sense. Investors also forget that, unlike

Treasury bonds, municipal bond issuers occasionally default.

Tax-free municipal bonds never make sense in IRA accounts,

even for high bracket taxpayers, since they are eventually

taxed in such accounts. High bracket investors are better

served by holding taxable bonds inside their tax-deferred

accounts (IRA, 401k, etc.) when possible. Finally, since the

Alternative Minimum Tax (AMT) can sneak up on munici-

pal bond investors, professional tax advice may be warranted.

While municipal bonds offer opportunity, they need to be

handled with caution. They require continual monitoring of

tax brackets, yield curves and personal tax circumstances.

Municipal Bonds Generally Offer Higher After-Tax Yields

1 8


1 9

Figure 15

Figure 16

Municipal Bond Taxable Equivalent YieldsTaxable Equivalent Yield = Tax-Free Yield/(1–Marginal Tax Rate)

Tables incorporate revised 2003 tax rates.

Revised Tax Tables Pursuant to Jobs and GrowthTax Relief Reconciliation Act of 2003

M U N I C I P A L MARGINAL TAX BRACKETSTAX-FREE YIELD 1 0 % 1 5 % 2 5 % 2 8 % 3 3 % 3 5 %

1 . 0 1.11 % 1.18 % 1.33 % 1.39 % 1.49 % 1.54 %

1 . 5 1 . 6 7 1 . 7 6 2 . 0 0 2 . 0 8 2 . 2 4 2 . 3 1

2 . 0 2 . 2 2 2 . 3 5 2 . 6 7 2 . 7 8 2 . 9 9 3 . 0 8

2 . 5 2 . 7 8 2 . 9 4 3 . 3 3 3 . 4 7 3 . 7 3 3 . 8 5

3 . 0 3 . 3 3 3 . 5 3 4 . 0 0 4 . 1 7 4 . 4 8 4 . 6 2

3 . 5 3 . 8 9 4 . 1 2 4 . 6 7 4 . 8 6 5 . 2 2 5 . 3 8

4 . 0 4 . 4 4 4 . 7 1 5 . 3 3 5 . 5 6 5 . 9 7 6 . 1 5

4 . 5 5 . 0 0 5 . 2 9 6 . 0 0 6 . 2 5 6 . 7 2 6 . 9 2

5 . 0 5 . 5 6 5 . 8 8 6 . 6 7 6 . 9 4 7 . 4 6 7 . 6 9

5 . 5 6 . 1 1 6 . 4 7 7 . 3 3 7 . 6 4 8 . 2 1 8 . 4 6

6 . 0 6 . 6 7 7 . 0 6 8 . 0 0 8 . 3 3 8 . 9 6 9 . 2 3

M a r r i e d M a r r i e d Head of Trusts &S i n g l e Filing Jointly* Filing Separate H o u s e h o l d E s t a t e s

1 0 % � $ 7 , 0 0 0 � $ 1 4 , 0 0 0 � $ 7 , 0 0 0 � $ 1 0 , 0 0 0 N / A

1 5 % $ 7,001 – 2 8 , 4 0 0 $ 14,001 – 5 6 , 8 0 0 $ 7,001 – 2 8 , 4 0 0 $ 10,001 – 3 8 , 0 5 0 � $1,900

2 5 % 28,401 – 6 8 , 8 0 0 56,801 – 1 1 4 , 6 5 0 28,401 – 5 7 , 3 2 5 38,501 – 9 8 , 2 5 0 $ 1,901 – $ 4,500

2 8 %* * 68,001 – 1 4 3 , 5 0 1 114,651 – 1 7 4 , 7 0 0 57,326 – 8 7 , 5 5 0 98,251 – 1 5 9 , 1 0 0 4,501 – 6 , 8 5 0

3 3 %* * 143,501 – 3 1 1 , 9 5 0 174,701 – 3 1 1 , 9 5 0 87,351 – 1 5 5 , 9 7 5 159,101 – 3 1 1 , 9 5 0 6,851 – 9 , 3 5 0

3 5 %* * 311,950 + 311,951 + 155,876 + 311,951 + 9,351 +

* Includes surviving spouses. Marriage Penalty Relief scheduled to sunset 12/31/04.

* * Marginal effective tax rate may be higher due to phaseouts of personal exemptions, itemized deductions and imposition of Alternative Minimum Taxes (AMT).

M A R G I N A LFEDERAL TAX RATE


2 0

Index and Tax-Engineered Balanced Investment Strategies Benefitfrom Forgiveness of Capital Gains Taxes Upon Death 3 1

(Assumes 20-year holding period comparing returns at death vs. liquidation at end.) Figure 17

Annual Gifting with Cash Figure 18

M A R G I N A L C A S H T A X N E TY E A R TAX RATE D E S C R I P T I O N D I S B U R S E D S A V I N G S C O S T

1 3 5 % Cash to Charity $ 5 , 0 0 0 $ 1 , 7 5 0 $ 3 , 2 5 0

2 1 5 % Cash to Charity 5 , 0 0 0 7 5 0 4 , 2 5 0

3 15% Cash to Charity 5 , 0 0 0 7 5 0 4 , 2 5 0

T o t a l s $ 1 5 , 0 0 0 + $ 3 , 2 5 0 = $ 1 1 , 7 5 0

Alternative Gifting Strategy: Gift AppreciatedSecurities to a Donor Advised Fund (DAF) Figure 19

M A R G I N A L C A S H T A X N E TY E A R TAX RATE D E S C R I P T I O N D I S B U R S E D S A V I N G S C O S T

1 3 5 % Gift $15,000 in Stock to DAF

(Cost Basis of $7,500) $ 0 $ 6 , 3 7 5 $ 8 , 6 2 5

Direct $5000 from DAF to Charity 5 , 0 0 0 0 0

2 1 5 % Direct $5000 from DAF to Charity 5 , 0 0 0 0 0

3 15% Direct $5000 from DAF to Charity 5 , 0 0 0 0 0

T o t a l s $ 1 5 , 0 0 0 + $ 6 , 3 7 5 = $ 8 , 6 2 5

Tax-Advantage of DAF S t r a t e g y $ 11,750 – $ 8,625 = $ 3,125

Pre-Tax HistoricalEquity Return (1926 – 2002)

( L i q u i d a t e ) ( D e a t h )

T.M. Equity Index Fund (After-Tax)3 1


60/40 Tax-Engineered( A f t e r - T a x )3 1


Equity Index Fund in IRA (After-Tax)3 1


Equity Index Fund in Variable Annuity

( A f t e r - T a x )3 1


Typical Active Equity Fund( A f t e r - T a x )3 1

1 0 . 2 0 %9 . 7 7 %

0 . 6 3 %9 . 1 4 %8 . 5 6 %

8 . 2 5 % 0 . 3 1 %8 . 0 7 %8 . 0 7 %

7 . 8 0 %7 . 8 0 %6 . 1 6 %6 . 1 6 %

ANNUAL SAVINGS FROM

STEP-UP IN BASIS AT DEATH


Effective tax-engineering combines the strategies of

tax elimination, tax reduction and tax deferral to

achieve optimal tax efficiency. As such, long-term

planning opportunities are available that benefit investors,

their families and frequently charities. Investors can utilize a

number of different gifting and charitable strategies to

reduce or eliminate deferred gains that build up over time.

Only Uncle Sam loses out!

Most people don’t know that unrealized capital gains are

completely forgiven at death.3 0 While long-term capital gains

during life are taxed at rates of up to 15%, even the wealthi-

est Americans escape tax on unrealized capital gains at death.

If Bill Gates sold his Microsoft stock tomorrow, he would

pay 15% in capital gains tax on the sale. However, if Mr.

Gates were to die and his family was to sell the stock after his

death, the taxable gain would vanish. They would save the

15% capital gains tax—permanently! This permanent elimi-

nation of capital gains tax at death is referred to as the “step-

up in basis” and is available to almost every investor.3 0

Benjamin Franklin once observed, “In this world nothing is

certain but death and taxes.” For once, here’s a case where

death at least eliminates one layer of tax!

Figure 17 illustrates potential tax savings from the step-up

in basis. On page 20, we noted that equity investors have his-

torically earned 10.2%. Assuming that trend continues, after

expense and taxes, a tax-managed index fund should earn

9.14%. This assumes liquidation and payment of tax on

deferred gains after 20 years. However, if the same investor

passes away after 20 years, the step-up in basis increases the

return to heirs by 0.63% annually, from 9.14 to 9.77%. In

contrast, IRAs, variable annuities and other tax-deferred

accounts are not eligible for this “step-up in basis.”

Gifting strategies (to family or charity) can provide an

earlier opportunity to achieve the same result as the step-up

in basis. High bracket taxpayers often gift highly appreciated

stock to family members in lower tax brackets. Upon sale,

capital gain rates can decline from 15% to 5%,3 2 or possibly

even less. Charitable gifts of appreciated stocks offer even larg-

er tax benefits. The donor gets a charitable deduction for the

full value of the stock at rates of up to 35% and permanently

eliminates any unrealized capital gains. As such, a 35% tax

bracket investor making a $15,000 gift of appreciated stock

(with a basis of $7,500) would enjoy total tax savings of

$ 6 , 3 7 5 .3 3 Thus, the net cost of the gift is only $8,625. 3 3

There are many tax-efficient charitable gifting strategies

available (i.e. CRUTs, CLATs and CRATs). Their benefits vary

with your tax rate, charitable intent, and estate planning needs.

A little known example is the Donor Advised Fund (“DAF”).

These are particularly effective for high bracket taxpayers who

are expecting a drop in their tax rates over the next few years.

Figures 18 and 19 compare outright gifts of cash to using a DAF

to leverage identical gifts. We assume an investor donates

$5,000 to their designated charity for three consecutive years. In

year one, they are in the 35% tax bracket. In years two and three,

they expect to be in the 15% tax bracket. Figure 18 shows the

three-year, after-tax cost of a $15,000 cash gift as being $11,750.

In contrast, using a DAF to make identical gifts (Figure 19) has

an after-tax cost of $8,625—a $3,125 tax savings!

In the example, the investor contributes $15,000 of

appreciated stock in year one to the DAF (when their tax

rate is high). This charitable deduction eliminates the

$7,500 in unrealized capital gains on the $15,000 of appre-

ciated stock. The investor gets an immediate tax deduction

for what would have been three years of contributions.

However, the DAF still enables the donor to control the tim-

ing of the actual disbursements of DAF assets. Thus, they

can make the same $5,000 per year gift from the DAF to

their designated charity.

Long-Term Planning Strategies Eliminate orReduce Tax on Appreciated Investments

2 1


The power to tax is the power to destroy,” John

Marshall once proclaimed. While we can begrudge

the politicians for their propensity to tax, we are

probably better off conceding, like Ben Franklin, that “taxes

are one of the certainties of life.” We also believe that an

investor’s desire to reduce taxes is fairly certain. Thus, tax-effi-

cient investing involves arranging one’s financial affairs in such

a way as to avoid paying any more tax than the law requires.

Making investment decisions in light of tax consequences

is both an art and a science. While many tax management

techniques are small, collectively they add up to real value.

Some decisions are straightforward and clear while others

require difficult judgment calls. These decisions require the

investor to quantify the tax benefits and be aware of current-

ly available strategies. Our primary objective with this paper

was to provide information regarding the practical applica-

tion, modeling and quantification of several different tax

strategies that exist after the 2003 tax act.

Tax-efficient investors should remember several key rules,

i n c l u d i n g :

• Be open to education about tax matters

• Active management is inherently tax-nasty

• Most traditional tax-advantaged products are gimmicky

and should be avoided

• Tax laws are dynamic and continually changing

• Think about and evaluate your portfolio as a whole

• Proper asset location and tax efficiency are synonymous

• Harvest losses by selling your losers, even if it hurts

• Be wary of conventional wisdom and outdated beliefs

• Weigh tax benefits against marginal risk and cost

• Only after-tax returns matter

Taxes should be an important consideration for all

investors, maybe the most important. The bad news is that

taxable investing is both counter-intuitive and difficult.

While tax-smart investing does offer intellectual challenges, it

also offers the most basic of tangible rewards—more money

in your pocket. It’s an effort worth pursuing.

We believe that tax-efficient investing requires a knowl-

edgeable coach. Tax management may be the single most

valuable contribution offered by an effective financial

advisor. To add value, an advisor needs to use a disci-

plined, systematic and integrated process.

Though tax-efficient investing might be easy to ignore in

the short-term, it is hugely beneficial over the long-term.

Getting it right may be the difference between success and

failure in a long-term financial plan. We relate well with the

late entertainer Arthur Godfrey, who said, “I’m proud to be

paying taxes in the United States....the only thing is, I

could be just as proud for half the money!”

Tax-Efficient Investing is a Disciplined andSystematic Process—Not a Product or Event

2 2


2 3

References and Methodology

1 Dickson, Joel and John Shoven. Schwab Commissioned Study. Stanford University Center forEconomic Policy Research.

2 Brunel, Jean L.P. 2002. Integrated wealth management: The new direction for portfolio managers.London: Institutional Investor Books, Euromoney Institutional Investor Plc.

3 While we have limited the focus of this paper to strategies designed to maximize after tax-wealthfor existing portfolios, a future paper may instead focus on financial planning strategies that canbe used to efficiently accumulate and liquidate assets.

4 We assumed the individual investor is in the top marginal federal tax bracket (35%). Given themultitude of state tax rates, we assumed investors are not taxed at the state level. While this isaccurate for states such as Florida and Texas, investors residing in high tax states, in particular,need to consider the impact of the state tax on their overall investment strategy. We also assumedthe investor is not subject to the Alternative Minimum Tax (AMT). Investors subject to this taxshould consult a qualified tax advisor to determine if the strategies contained herein, apply totheir specific situation. For example, AMT investors frequently include individuals living in highincome tax states, those with very high itemized deductions, investors with large capital gains,and individuals with significant private activity municipal bond income. We also assumed thatrecent 2003 legislated law changes, some of which are scheduled to sunset in the future, areextended indefinitely. We make this assumption given that we believe the current state of taxlaw is the best predictor of future tax rules. Strategies discussed in this paper may be negativelyimpacted by future legislation or if the law actually sunsets.

5 Malkiel, Burton G. 1999. A Random Walk Down Wall Street, W.W. Norton & Co, Inc., NewYork, NY.

6 William Reichenstein & William Jennings. 2003. Integrating Investments and the Tax Code.John Wiley & Sons, Inc., Hoboken, New Jersey

7 Jeffery, Robert H. 1995. Tax considerations in investing. In The portable MBA in investments,edited by Peter L. Bernstein. New York: John Wiley & Sons, Inc.

8 Jeffery, Robert H. and Robert Arnott. 1993. Is your alpha big enough to cover its taxes? Journalof Portfolio Management, Spring 15-25.

9 To calculate expected after-tax return on active strategies, we assumed that investors earned grossequity returns of 10.2% (see endnote #11 below) reduced by fund expenses, trading costs, andtaxes. The estimated after-tax returns are calculated using an algorithm developed by John B.Shoven in his March 1999 working paper titled “The location and allocation of assets in pensionand conventional savings accounts.” Working paper 7007, National Bureau of EconomicResearch. The gross total return of 10.2% includes capital gains and dividend yield. On allactively managed strategies, we assumed a dividend distribution yield, taxed at ordinary incomerates, of 0.27% per year. This is based on the average equity fund yield in Morningstar Principiaas of 12/31/2002. To determine realized and unrealized capital gains, gross returns are reducedby expense ratios, dividends, and trading costs. We assumed an average expense ratio of 1.52%based on the average equity fund internal expense ratio in Morningstar Principia as of12/31/2002. We further estimate total trading costs are equal to 1% per annum per 100% port-folio turnover. This is based on various industry estimates of commissions, bid-ask spreads, andmarket impact. While the average equity fund turnover per Morningstar as of 12/31/2002 was100% per annum, we arbitrarily assumed low turnover funds averaged 25% turnover while highturnover funds averaged 200% turnover. We further assumed that, in each year, investors real-ized both long and short-term capital gains. In the case of low turnover funds, we assumed 90%of capital gain is taxed at long-term rates and 10% is taxed at short-term rates. For averageturnover funds, we assumed 75% of realized gains are taxed at long-term rates while 25% is taxedat short-term rates. For the high (200%) turnover strategy, we assumed all gains are realizedannually at short-term rates. In practice, even funds with very high turnover may defer some cap-ital gain if they retain a portion of their appreciated holdings at year end. For all actively man-aged strategies, we assumed the investor liquidates his entire position at the end of twenty yearsand pays the maximum long-term capital gains tax on any unrealized appreciation.

10 The after-tax returns for tax-managed equity index funds and Exchange Traded Funds (“ETFs”)assumed investors earn gross equity returns of 10.2% (see endnote #11 below). On tax-managedequity index and ETF strategies, we assumed a dividend distribution yield, taxed at ordinaryincome rates, of 1.51% per year. This is based on the 30-day SEC yield for the Vanguard TotalMarket Index as of 12/31/02. To determine unrealized capital gains, gross returns are reducedby expense ratios, dividends, and trading costs. We assumed total fund expenses and tradingcosts at 0.20% per year. Investors in several large stock and market wide index funds offered byThe Vanguard Group, Barclay (iShares) and State Street (SPDRS) incur total expenses at orbelow this level. Furthermore, we assumed no realized capital gains—long-term or short-term—on this fund until liquidation. We assumed all gains are deferred until liquidation at the end oftwenty years. We believe this is a reasonable assumption based on the historical experience ofexchange traded funds and Vanguard tax-managed index funds.

11 We assumed a gross equity return (before expenses) of 10.2% for all equity performance calcu-lations. This applies to tax-managed index funds, exchange traded funds, and actively managedfunds. This return is based on the total return of the S&P 500 from 1926-2002, according toIbbotson Associates. While there is some debate regarding the possibility of reduced expectedequity returns in the future, it is beyond the scope of this paper to address that possibility.Accordingly, we simply assumed that equities perform at their historical return levels.

12 Sharpe, William F. mathematically demonstrated this logic in his 1991 article The Arithmetic ofActive Management, as published in the Financial Analysts Journal. January/February 1991 7-9

13 In Figure 2, we calculate the excess return (alpha) required to outperform a tax-managed fund orETF (after accounting for taxes). We used the same methodology as described in endnotes #9and #10 above. However, instead of assuming 10.2% gross equity returns for the actively man-aged strategies, we determined the gross return required for such strategies so as to merely equalthe after-tax return of a tax-managed index or ETF. The actively managed strategies need to earnpositive pre-tax alpha just to break even with an index strategy after-taxes. This is due to thehigher expenses and taxes inherently associated with active management.

14 The 1.4% after-tax average benefit of winning the “active” management bet is based on the aver-age net-of-tax performance advantage of the top 8% of funds in Morningstar Principia, afteradjusting for taxes. The performance advantage is relative to the net-of-tax returns of theVanguard 500 Portfolio during the 15-year period ending 12/31/00. The 9.7% average cost oflosing the “active” management bet is based on the average performance disadvantage of theworst 8% of funds in Morningstar Principia relative to the Vanguard 500 Portfolio.

15 Unlike investors’ taxable investments, annuity owners do not benefit from potential step-up inbasis opportunities (see pages 20-21). At death, all gains distributed from variable annuities aretaxed at the top marginal tax rate, as all capital gains and qualified dividends are essentially con-verted to ordinary income inside an annuity wrapper.

16 The after-tax returns for variable annuities assumed investors earn gross equity returns of 10.2%(see endnote #11 above). To determine after-tax returns, gross returns are reduced by expenseratios and mortality and expense (M&E) charges. To simplify, we ignore trading costs. In thecase of the lowest cost variable annuity illustrations, we base our calculations on the VanguardVariable Annuity. The combined expense ratio (Total Market Index) and M&E charge on thisannuity is 0.5% per annum. In the case of the average cost variable annuity, we use the averagetotal expenses for equity variable annuities in Morningstar Principia as of 12/31/02. We furtherassumed the investor incurs no early surrender fees and all gains are deferred until liquidation atthe end of twenty years. A 10% surrender penalty, on earnings, is applied to pre-59 1/2 distri-butions.

17 When comparing the net returns (after taxes and cost) of variable annuities versus traditionalequity funds, it is helpful to compare the potential net returns for annuities (with their highercosts) to traditional mutual funds. Vanguard offers the lowest cost annuity in the industry. Theyalso offer traditional mutual funds. For example, they offer the total stock market index bothoutright and inside their variable annuity. While the expense ratios for the funds are the same,the annuity has an additional 0.3% M&E charge. This additional charge gives the investor thebenefit of tax-deferral. The challenge for the annuity is that its marginal cost exceeds any taxadvantage. For example, at present, a total stock market fund, even in the traditional mutualfund format, is not expected to cause investors to realize annual capital gains. Instead, capitalappreciation is most likely deferred until liquidation—just like occurs in the annuity version.Thus, the only advantage to the annuity is deferral of taxes on the dividend yield. Furthermore,such dividends are taxed at a current maximum rate of 15%. Current dividend yields are approx-imately 1.51% (as of 12/31/2002). Accordingly, the dividend tax cost of not deferring taxes onthe traditional fund’s dividend yield is 0.225% (1.51% x 15%). Thus, the annual tax savings isless than the cost of the annuity (0.30%). Even if the analysis ended there, annuities would bea bad deal. However, upon further review, annuities only get worse. The annuity does not actu-ally eliminate tax-it merely defers it. They also convert tax advantaged long-term capital gains(15%) and qualified dividends (15%) to higher-taxed ordinary income (35%). Thus, in total, itis mathematically impossible for investors to come out ahead in annuities. Also, for the averageannuity (that is far more expensive than Vanguard’s), the hurdle is even larger.

18 While the 2003 tax bill did not change the taxability of §529 plans, it did make traditional mutu-al funds more desirable. For assets invested outside §529 plans, the tax rates on both qualifieddividends and long-term capital gains (incurred by traditional equity mutual funds) fell to a max-imum rate of 15%. This reduced the tax drag of investing outside of the §529 thus narrowingthe gap between investing in §529 plans and traditional outright ownership. Now, the additionalcost of the §529 plan’s administrative fees (i.e. Vanguard offers the lowest cost §529 equity indexfund at 0.65% through the Nebraska UPromise plan) often exceeds the tax savings offered such§529 plans. This is particularly the case if §529 distributions are not actually used for qualifiededucational expenses. Thus, people should now reconsider direct ownership strategies thatinvolve gifting assets to the student at or prior to the student’s incurring actual educationalexpense.

19 The §529 analysis is based on Vanguard’s flagship §529 plan sponsored by the state of Nebraskaand administered by UPromise. Other higher cost plans result in projected returns substantial-ly below those attainable by investing directly in tax-managed index funds.

20 “Core and Structured SatelliteTM” is a proprietary term used by Savant. It is distinctly differentfrom the widely used industry term “core and satellite”. “Core and satellite” traditionally meansthat the core of a portfolio (typically 50-80%) is held in a market based index. The goal of thecore is to provide diversification, low costs, tracking relative to the broad market and tax-effi-ciency. The remainder is invested in a more extreme and actively managed style. Often times,satellites include active stock pickers, hedge funds, private equity, vehicles used for market tim-ing (frequently referred to as tactical allocation) and speculative bets. In contrast, while “Coreand Structured SatelliteTM” use a similar core, the Structured SatellitesTM instead consist of stylebased ETFs, index, structured, and passive funds. No timing, active management or speculatingtakes place. Instead, the satellites become strategic buy-and-hold positions that allow the investorto tilt their portfolio towards asset classes underrepresented by the broad market. The goal is toenhance return and reduce risk through better structured portfolio design. “StructuredSatellitesTM” can include asset classes such as microcap stocks, value stocks, international stocks,and emerging market stocks. The premise of this strategy is the belief that markets are efficient,broad global asset allocation is of utmost importance, timing and tactical allocation is risky,expensive and provides little or no benefit, and tax management needs to be central to the invest-ment decision.


References and Methodology

2 4

21 As of 6/30/2003, the Wilshire 5000, Russell 3000 and Dow Jones Total Stock Market indexesrespectively covered 100%, 89.5% and 87.5% of the total U.S, market capitalization. TheRussell 3000 and Dow Jones Total Market Index includes a smaller percentage of the overall mar-ket as the result of various float-adjustments and liquidity screens that assure investability.

22 These asset classes are often best held in IRA, pension or Roth accounts since they are generallyless tax-efficient. To the extent such qualified accounts are unavailable, tax-managed funds canoften eliminate much of the tax otherwise associated with less tax-efficient Structured SatelliteTM

asset classes.

23 Unlike traditional open-ended mutual funds issued and redeemed directly by sponsoring fundcompanies, ETFs are bought and sold on public exchanges like stocks. Investors buy and sellshares from market makers who maintain inventories of shares (for liquidity purposes). Whenthe market maker’s inventory runs low (more buyers than sellers exist), the market maker pur-chases the underlying securities held by the ETF in the open market, presents a basket of suchsecurities to the ETF fund company, and in return, receives newly created ETF shares for replen-ishing their inventory. Likewise, market makers with too much inventory (more sellers than buy-ers) present their surplus ETF shares to the fund company. The fund company redeems suchshares by unbundling the underlying securities owned by the ETF and returning the basket ofsecurities to the market maker. Most often, the fund complex systematically identifies, unbun-dles and passes back to the market maker the lowest cost basis securities. This cleanses theremaining ETF portfolio of potential unrealized capital gains. As result, ETFs are inherentlymore tax-efficient in that traditional funds do not have a similar “back door” to flush out poten-tially tax-nasty low basis stock.

24 The gross portfolio return of 9.3% is a blended and weighted average of historical U.S. marketindex returns from 1926-2002 derived from a portfolio consisting of 40% S&P 500, 40%Ibbotson Intermediate Bond Index and 20% Ibbotson U.S. Small Stock index.

25 Expenses for implementing the “Tax-engineered 60/40 using core tax-managed index andStructured SatelliteTM” were assumed to be 0.20% (expense ratio and trading costs) for the coremarket index. This could be accomplished using the Vanguard Total Market Index, theVanguard Tax-Managed Growth & Income, the Vanguard Index 500 Portfolio or any of severalexchange-traded market index funds. For bonds, we likewise assumed 0.20% combined expenseratio and trading costs. This can be accomplished using several Vanguard bond index funds,iShares Lehman 7-10, iShares Lehman Aggregate, or Scudder U.S. Bond Index Premier fund. Inthe case of small stocks, we assumed the investor utilized the Dimensional U.S. Microcap fund.This fund’s expense ratio at 12/31/2002 was 0.56%. We further assumed trading costs incurredby the fund to be an additional 0.22% based on the fund’s 10-year average portfolio turnover of22% and assumed transaction costs of 1% per 100% turnover. In regard to taxes, we assumedthat the taxable account is invested in the core market index and pays a qualified dividend of1.51%. All capital gains are deferred until liquidation. Appreciation in bonds is deferred in theIRA account while small stocks grow tax-free in the Roth IRA. To simplify, we further assumedno rebalancing over the 20 year holding period. In the case of the step-up scenario, we assumeddeferred capital gains are eliminated at the end of 20 years due to death. In the case of the liq-uidation scenario, we assumed all unrealized capital gains are taxed at the end of 20 years.

26 The same expense and fund assumptions were used for the “Tax-backwards 60/40 using coreindex fund and Structured SatelliteT M” as discussed in #25 above. In regards to taxes, weassumed the taxable account is equally invested in small stocks (Structured SatelliteT M) andbonds. In the case of bonds, we assumed their entire return came in the form of dividendincome taxed annually as ordinary income. On bonds, we assumed no capital gain or loss. Inthe case of small stocks, we utilized the 12-month distribution yield of 0.19% as reported inMorningstar as of 12/31/2002. Based on historical experience, we assumed that all capitalgains, on average, are distributed on an annual basis. Also based on historical experience, weassumed that 90% of such gains are taxed as long-term gains while 10% are short-term innature. Appreciation in the core market index is deferred in the IRA account while bonds inthe Roth IRA grow tax-free. We further assumed no rebalancing over the 20 year holding peri-od. In the case of the step-up scenario, we assumed deferred capital gains are eliminated at theend of 20 years due to deat h. In the case of the liquidation scenario, we assumed all unrealiz edcapital gains are taxed at the end of 20 years.

27 To estimate expenses involved in implementing the “Tax-backwards 60/40 using active core andactive Satellite StrategiesTM”,we assumed the average actively managed equity fund had an expenseratio of 1.52% based on 12/31/2002 Morningstar data. Additionally, we estimated total equitytrading costs to add an additional 1% expense per annum. This is based on the 100% averageportfolio turnover incurred by the equity funds tracked by Morningstar as of 12/31/2002. Weassumed this 100% turnover equated to 1% trading cost per year. This estimated trading costincludes commissions, bid-ask spreads and market impact. In the case of bonds, we utilized theaverage bond expense ratio of 1.03%. We assumed trading costs added an additional 0.10% peryear. In regards to taxes, we assumed the taxable account is invested equally in small stocks(Structured SatelliteTM) and bonds. In the case of bonds, we assumed their entire return came inthe form of dividend income taxed annually as ordinary income. On bonds, we assumed no cap-ital gain or loss. In the case of stocks, we utilize the average equity fund 12-month distributionyield of 0.27% as reported in Morningstar as of 12/31/2002. We assumed that all capital gainsare distributed annually. Also based on historical experience, we assumed that 75% of such gainis taxed as long-term gain while 25% is short-term in nature. Stock appreciation is deferred inthe IRA account while the bonds in the Roth IRA grow tax-free. We further assumed no rebal-ancing over the 20-year holding period. In the case of the step-up scenario, we assumed deferredcapital gains are eliminated at the end of 20 years due to death. In the case of the liquidationscenario, we assumed all unrealized capital gains are taxed at the end of 20 years.

28 When computing tax, you first offset short-term gains and losses. Both are incurred when aninvestment is held less than 12 months. Surplus short-term gain is taxed at ordinary tax rates upto 35%. Likewise, long-term gains and losses (positions held over 12 months) are offset.Remaining long-term gain is taxed up to 15%. However, once short-term gains and losses areoffset, surplus long-term losses offset unlimited tax-nasty short-term gain plus an extra $3,000(per year) of ordinary income—both typically taxed at up to 35%.

29 YieldQuest Research/Bloomberg

30 Currently, all taxpayers benefi t from step-up in basis upon death. As currently legislated, oncethe estate tax is repealed in 2010, certain very high net worth individuals may lose the abilityto receive a st ep-up on a portion of their assets upon death. Also, as currently legislated, whenthe current tax law sunsets in 2011, estate tax is reinstituted and step-up in basis rules will bereinstated. Given the complexity of these rules and uncertainty regarding future legislation,we simplified our analysis to assume that step-up in basis indefinitely remains intact for allinvestors. High net-worth investors should consult with their tax advisor for specific applica-tion of this tax legislation.

31 The 10.2% pre-tax historical equity return is based on the S&P 500 from 1926-2002. The9.14% (Liquidate) return for the T.M Index Fund is calculated in the same manner as discussedin endnote #10 above. The 9.77% T.M. Index Fund (Death) return uses the same methodolo-gy as discussed in endnote #10 except that unrealized capital gains receive step-up in basis due todeath. The 0.63% annual savings is the difference between 9.77% and 9.14% when step-up isrealized. In the 60/40 Tax-Engineered (Liquidate), we utilized the same assumptions andmethodology discussed in endnote #25. In the 60/40 Tax-Engineered (Death) scenario, we usethe same assumptions and methodology in endnote #25 except that unrealized capital gains arestepped up in basis due to death. The 0.31% annual savings is the difference between 8.56%and 8.25% where step-up in basis is realized. In the case of the Index Fund in IRA, the returnis 8.07% in either (Liquidate) or (Death) since no step-up is available on an IRA account. Tosimplify the analysis, we assumed no stretch-out IRA option is selected by the beneficiary of theIRA at death but instead distributed and taxed at the top marginal ordinary income tax bracket.This may overstate the tax if, unlike the deceased owner; the beneficiary is actually in a lower taxbracket. In the case of the Index Fund in Variable Annuity, the return is calculated in the samemanner as discussed in endnote #16 in the case of (Liquidate) or (Death) since annuities offer nostep-up. To simplify the analysis, we assumed the annuity beneficiary, like the deceased owner,is a top marginal tax bracket tax payer. This overstates the tax if the beneficiary is actually in alower bracket. The 6.16% Typical Active Equity Fund for both (Liquidate) and (Death) is cal-culated using the same methodology and assumptions as discussed in endnote #9. Our analysisassumes there is no step-up in basis opportunity since all capital gains are assumed to be realizedannually. While this is overly simplified, we believe it reasonable since portfolio turnover for theaverage equity fund is 100% as of 12/31/2002. However, since portfolio turnover is not alwaysa perfect predictor of realized capital gains distributions, actual distributed gains may be more orless than 100% of actual capital gains.

32 Assumes family member is in a 15% or lower ordinary income tax bracket.

33 The donor receives two tax benefits from donating appreciated securities. First, they receive anordinary income tax deduction for the $15,000 in-kind gift of securities at maximum ordinarytax rates of 35% ($15,000 x 35% = $5,250). Second, by donating appreciated securities, theunrealized capital gain on such securities is forgiven as the securities are sold by the charity(whose capital gain tax rate is 0%). Thus, gifting the $15,000 securities with a cost basis of$7,500 eliminates a $7,500 unrealized capital gain ($15,000 - $7,500 = $7,500). Tax on theforegone $7,500 unrealized gain would have been $1,125 since the $7,500 unrealized capitalgain would have otherwise been taxed at a maximum capital gain rate of 15%. Thus, the giftresults in total tax savings of $6,375 ($5,250 + $1,125). Accordingly, the net cost of the $15,000gift is only $8,625 ($15,000 - $6,375).

34 Many variables need to be considered when considering the efficiency of holding municipalbonds in an investor’s taxable accounts. For low tax-bracket investors, municipal bonds typi-cally do not make sense. They generally yield less than taxable bonds. Thus, low tax bracketindividuals are often better off owning taxable bonds-even after paying some tax. Municipalbonds also generally make little sense for investors with a large portion of their assets in annuity,pension or IRA accounts. In such cases higher yielding taxable bonds can instead be held andsheltered in such accounts. Municipal bonds often make the most sense for high tax bracketinvestors, with a significant allocation to bonds who own mostly taxable investments. Investorsin high tax states also benefit from holding municipal bonds in taxable accounts. Investors sub-ject to alternative minimum tax need to be careful in owning private activity municipal bondssince they can cause taxation regardless of their tax-free nature. In such cases, these investors aregenerally better off owning taxable bonds.

35 We bolded both the “Better” and “Best” labels for tax nasty-stocks. If one owns a Roth IRA,this is the best location for owning tax-nasty stocks. Since most investors do not own a largeRoth IRA account, we also identify tax-deferred accounts as an acceptable “Ideal” location fortax-nasty stocks.

36 Bigcharts.com reported listings for 8459 publicly traded stocks as of 12/4/2003. This includ-ed 2945 NYSE, 663 AMEX, 3231 NASDAQ and 1620 Bulletin Board issues.


Savant is an independent, fee-only wealth management

firm. We offer investment management, financial planning

and family office services to financially established individ-

uals, trust funds, retirement plans, non-profit organiza-

tions, and fiduciaries.

Our clients are neither speculative nor high-risk

investors. All are concerned with preserving capital, grow-

ing assets, and avoiding the myriad of risks that abound in

today’s investment environment. To meet these objectives,

we help you use the same Nobel Prize winning strategies

traditionally reserved for the largest institutional investors.

As a f e e - o n l y advisor, Savant receives no compensation

or benefit from brokerage services, commissions or finders

fees. In fact, whenever possible, we help you eliminate

commissions. Our independence allows us to remain

impartial in helping you secure specialized investment ser-

vices from leading institutional providers.

We tailor each portfolio to your unique individual

needs. Yet, all clients share the goal of maximizing after-tax

wealth while controlling risk. Broad global diversification,

based on sound asset allocation principles, is an effective

means to this end. Accordingly, our portfolios incorporate

a broad array of asset classes that draw on investment

opportunities throughout the world.

Sophisticated investment tools help us assist you in deter-

mining the mix of assets best suited to your investment objec-

tives, risk tolerance, and goals. For individual investors, we

put tax considerations at the very center of the investment

process. One way we do this is by helping you identify the

most advantageous apportionment of your investment assets

among personal and tax-deferred retirement accounts. We

also help individual clients minimize confiscatory estate taxes.

S a v a n t follows a highly structured, systematic, and disci-

plined approach designed to maximize wealth in a conserva-

tive and well-thought-out manner. Our proprietary financial

planning process is called The Wise Wealth Integrator.T M

This step-by-step method helps you integrate your wealth

and wisdom to develop clear goals and a plan to achieve

them. Our investment process is called The Wise Wealth

Investment Solution.T M Each process works on a stand alone

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Savant earned a place on B l o o m b e r g ’ s Top Wealth Manager

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Approaching Zero Taxes - Savant Capital · Approaching Zero Taxes GO A L: CO M P L E T E L YEL I M I N A T ETA X 1 Approaching Zero Taxes - Savant 12/17/03 9:04 AM Page 3 “Active”