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Turnover & Tax Savings

In my 41 years of experience in the CPA business, I have never had anyone say to me that they wish they could pay more income tax.  Plenty have stated they would like more income, but none care to pay a higher percentage to the government.

For investors, there is one area that rarely gets any attention by their “financial advisor” or their CPA/tax preparer.  That is the wasted tax dollars caused by turnover in their portfolio.

I was reminded of this again recently when reviewing the portfolio of a very high income couple who are in the 42% tax bracket.  Their non-qualified (or non-IRA) investments are mostly mutual funds, some of which have very high turnover.  Turnover is the amount of buying and selling in the mutual fund.  The more buying and selling, the more costs and fees.  Also, the more buying and selling, the more tax you can pay.

The average turnover rate (in managed mutual funds), is almost 100% per year.  This means that the fund replaces each stock in the fund every year.  High turnover can occur when a fund manager is trying to “beat the market.”  The academics do not support this philosophy of investing, however.  We are always better off using a passive approach which you might call “buy and hold.”  There are several benefits to this strategy, and significantly lower taxes is one of them.

One study set out to calculate the cost of average turnover as a % of a portfolio.  The conclusion was 2.6%.  It follows, then, that turnover can consume about 1/3 of an 8% return each year.  Why many investment advisors don’t manage turnover is beyond me.

Category: Coach's Corner

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