America’s fast-growing pile of debt suggests investors should start to focus on tax-efficient investment strategies, according to Bank of America.
The bank noted that the $34 trillion in US debt is poised to exceed 100% of GDP by July, approaching its record 112% of GDP reached during World War II.
Only 13% of government spending is non-defense discretionary, while the other 87% is “politically untouchable mandatory entitlement spending” like Social Security and Medicaid, defense spending, or net interest expense.
So, how does it all end?
“Not with drama or default, but with taxes or with the hushed acceptance of that universal tax: inflation,” Bank of America’s Research Investment Committee said in a note on Tuesday.
That means looking forward, investors should prepare for either higher taxes or higher inflation, and in either scenario it makes sense to own stocks as the most tax-efficient strategy, according to the bank.
Here are five ways to boost the tax efficiency of investment portfolios.
1. Own ETFs over mutual funds
“ETFs are more tax efficient than mutual funds thanks to the creation and redemption process for shares,” Bank of America said.
“Mutual funds are sometimes forced to sell assets to meet redemption requests. Any realized capital gains from sales are distributed to shareholders, triggering a tax event. On average, mutual fund tax events cost investors 1.3% per year vs just 0.4% for ETFs.”
2. Stocks are more tax-efficient than bonds
“The income paid by US government bonds is taxable at federal ordinary income rates, up to 37% for top earners. Interest from cash accounts, I-bonds, and other fixed income is also taxable as ordinary income. Most equity payouts, however, are classified as qualified dividend income, and taxed at a maximum rate of 20%,” Bank of America said.
3. When owning bonds, focus on municipals
For investors’ bond allocations, it makes sense to focus on high-yielding issues in the municipal space, as well as preferred ETFs, which act as quasi-bond funds.
These two types of fixed-income investments not only get taxed at lower rates than Treasury bonds, but they’ve outperformed both the US Aggregate Bond Index and Treasury bonds over the long-term.
4. Stock buybacks are more tax-efficient than dividends
“Investors looking for long-term wealth accumulation should favor buybacks over dividends,” Bank of America said, arguing that buybacks offer “low-friction compounding.”
“Share repurchases are more tax-efficient than dividends. Even if dividends are qualified, payouts are taxed at the end of every year where they’re received. An investor who pays taxes on reinvested dividends has less money to compound every year. Holding companies that execute repurchase programs do not typically trigger a tax event until an investor sells their shares,” Bank of America said.
5. Take a second look at your portfolio
Investors should take a fresh look at their portfolio and audit the holdings to better understand their tax liability.
Investment products that typically come with a lower tax bill include MLP ETFs, US sector ETFs, and international stock ETFs. In all three cases, taxes can be lowered thanks to tax-exempt return on capital distributions or qualified dividend income.
