Dan Hunt: Hello, and welcome to another edition of Wealth Management Insights. I’m Dan Hunt, Head of Portfolio Construction & Investment Tools at Morgan Stanley Wealth Management.
For most people, investing is what you do because you want to retire with the lifestyle you’re accustomed to, put your kids through college or build a legacy. In other words, investing is a means to an end, not an end in itself. If you feel you’re not on track to meeting your goals, there are different ways to address such a situation. The most obvious of these are saving more, delaying the goal, or otherwise reducing its ambitiousness, or increasing your portfolio’s growth potential by increasing its risk. These options, however, tend not to be desirable even if they are feasible. What’s more, you may already have as much risk in your portfolio as you’re comfortable with, making further increases in risk inadvisable. What then?
One alternative that’s available to many investors is to become more tax efficient. In other words, to reduce the tax take of your investment earnings.
Taxes are a substantial drag on wealth accumulation because they hamper the powerful effects of compound growth rates. In other words, investors will never earn additional investment returns on the dollars that were paid out as taxes. So even small reductions in taxes can have a big impact on wealth accumulation over time.
There are several approaches to reduce the bite that taxes can take from investment returns.
First, consider securities and account types that are tax-exempt. Let’s take municipal bonds for example. While the yields on municipal bonds issued by US states and municipalities are generally lower than those of other issuers, all else equal, those interest payments are generally exempt from federal income taxes and, if the investor lives in the state of the issuer, from state and local taxes as well. This can often make their after-tax yields more attractive than taxable alternatives.
Second, look to structures and strategies that defer taxes to a later date. While this does not lower the absolute amount of taxes owed, it permits investors to earn compound returns unencumbered, which can make a massive difference to ultimate wealth. To defer taxes, investors can use account structures such as 401(k) plans and traditional IRAs, where investments can grow without incurring tax, which is typically assessed only when funds are withdrawn. Contributions to these accounts may also be tax deductible, which magnifies their potential impact. Taxes on taxable investments in taxable accounts can also be deferred to a certain extent, through carefully selecting security sales so as to minimize realized gains or to harvest losses, the latter of which creates near-term tax deductions.
Lastly, consider the combined effects of both tax-exemption and tax-deferral, as these securities and account types can work together to complementary effect. For example, tax-efficient asset location involves placing less tax-efficient and higher-growth investments in tax-advantaged accounts, and more tax-efficient and lower-growth investments in taxable accounts. This can significantly enhance the ability of tax-advantaged accounts to deliver tax benefits. Furthermore, for retirees who need to make withdrawals to cover spending needs, tax-efficient withdrawal strategies can help when it comes to electing the account types, securities and even tax lots that are used in a way that minimizes the tax hit. In that sense, working with your Morgan Stanley Financial Advisor to build a tax-efficient withdrawal strategy to meet your needs can help you stretch your retirement nest-egg to the fullest extent possible.
Tax-efficient strategies are not a guarantee of superior performance, but our research indicates that they hold out significant potential for improving the chances of meeting your financial goals. More importantly, they can accomplish this without exposing investors to additional investment risk.
While I’ve outlined a few examples of tax-efficient strategies, individual circumstances can make a big difference in what works best, so it’s important to review with a professional before making a determination. For a copy of an in-depth special report about these strategies, called “Tax Efficiency: Getting to What You Need By Keeping More of What You Earn,” or to learn how these strategies might fit into your portfolio and financial journey, please reach out to your Morgan Stanley Financial Advisor. Thank you for listening.
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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures and qualifications at the end of this material.
Risk Considerations
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Hypothetical Performance
General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Hypothetical performance results have inherent limitations. The performance shown here is simulated performance not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results.
Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs.
Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods.
This analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this analysis, your actual results will vary (perhaps significantly) from those presented in this analysis.
The assumed return rates in this analysis are not reflective of any specific investment and do not include any fees or expenses that may be incurred by investing in specific products. The actual returns of a specific investment may be more or less than the returns used in this analysis. The return assumptions are based on hypothetical rates of return of securities indices, which serve as proxies for the asset classes. Moreover, different forecasts may choose different indices as a proxy for the same asset class, thus influencing the return of the asset class.
Asset Class Risk Considerations
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.
Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.
The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. The companies identified and investment examples are for illustrative purposes only and should not be deemed a recommendation to purchase, hold or sell any securities or investment products. They are intended to demonstrate the approaches taken by managers who focus on ESG criteria in their investment strategy. There can be no guarantee that a client's account will be managed as described herein.
Tax-loss harvesting. IRS rules stipulate that if a security is sold by an investor at a tax loss, the tax loss will not be currently usable if the investor has acquired (or has entered into a contract or option on) the same or substantially identical securities 30 days before or after the sale that generated the loss. This so-called “wash sale” rule is applied with respect to all of the investor’s transactions across all accounts
Any type of continuous or periodic investment plan does not assure a profit and does not protect against loss in declining markets. Since such a plan involves continuous investment in securities regardless of fluctuating price levels of such securities, the investor should consider his financial ability to continue his purchases through periods of low price levels.
Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy.
The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.
The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time.
Disclosures
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.
The securities/instruments discussed in this material may not be appropriate for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor.
This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We and our third-party data providers make no representation or warranty with respect to the accuracy or completeness of this material. Past performance is no guarantee of future results.
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