Investment Fees Reexamined

More and more, it is becoming clear that fees are a large determinate of investment performance. In this month's issue of NAPFA Advisor, Vern Sumnicht, MBA, CFP, discussed a study by State Street Corp. and the Wharton School of Business that found just 43 percent of investors understand the fees associated with their investments even "fairly well." However, in a low-return environment, reducing costs becomes an increasingly critical way to improve investment returns for any portfolio.

The following is a portion of the study's findings:

"Typically, actively managed equity-based mutual funds without commissions (no-load) charge about 1 percent to 2 percent each year inside the fund, to manage and operate the fund. However, there are additional costs that are not typically considered in the cost equation. Transaction costs -- the costs to buy and sell stocks inside the fund -- can add another (undisclosed) 0.5 percent to 1.5 percent annually to an investor's cost to hold that mutual fund investment.

Additionally, when fund managers are faced with redemptions, they must sell securities from the fund's holdings to provide cash for the redemptions. When these securities are sold for a gain, the sale triggers a taxable event for the remaining investors holding the fund in non-qualified accounts, whether the investor has been a shareholder for 10 years or 10 days. Furthermore, many funds wait until late in December to make their capital gains distributions known, leaving little or no time for investors to make other decisions to offset the tax liability. These costs can add an additional 0.5 percent to 2 percent to the annual cost for investors."

Combining these fees, investing in a mutual fund can incur charges of between 2 percent and 5.5 percent -- obviously significant. Keep in mind, this study doesn't even account for any additional fees charged by a financial advisor for monitoring your account. This illustrates the importance of keeping a close eye on fees when analyzing potential investments.

Finally, the study affirms my belief that the advisors of Net Worth Advisory Group really do add tremendous value to their clients retirement planning efforts. In most cases, we charge no more than 1.5 percent for our services. This is an all-inclusive fee, covering investment management, transaction fees, and meeting twice a year to review investment performance and update your financial plan. Further, we invest our client's funds into individual stocks as opposed to mutual funds, saving them fees and allowing more control over tax implications. Lastly, our advisors shake the hands of our clients, develop personal relationships, and provide individual-specific advice -- something a mutual fund can never do.

Reducing Tax Liability in 2010 and Beyond

Tax planning has always been a very challenging element of the financial planning process. This year it has been especially difficult in light of the uncertainty associated with the pending changes to the tax code. As you may be aware, the tax cuts established by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (both of these acts are commonly referred to as the Bush tax cuts) are set to expire at the end of the year. There has been considerable debate as to whether or not these tax cuts should be extended. With a lame duck congress now in session, time will tell what the eventual outcome will be.

So how do we properly tax plan in the face of such uncertainty? It is crucial to understand your personal situation and how the pending changes could impact you. One of the primary concerns for many taxpayers is the possibility of higher income tax rates as early as next year. If the tax cuts are not extended the current low and high tax rates will increase from 10% and 35% to 15% and 39.6%. Additionally, the maximum capital gains rate will increase from 15% to 20%. Understanding how each case impacts your personal situation can be very helpful in preparing a strategy. Once you understand this you can begin to assess a probability to the potential outcomes and begin making critical tax planning decisions.

Without offering specific tax advice in this newsletter, the following ideas are typically very important considerations to make at the end of each year:

• As always, consider optimizing contributions to your tax-advantaged investment accounts (i.e. 401K, IRA, Roth IRA, etc.). Investment vehicles such as 401Ks and IRAs enable you to lower your current tax bill and achieve tax-deferred growth. Meanwhile, Roth IRAs and Roth 401Ks allow you to pay taxes at today's low rates and enjoy tax-free growth going forward.
• Consider a Roth IRA conversion. Having taxable, tax-deferred, and tax-free accounts could be part of a broader tax diversification and mitigation strategy.
• Be aware of your realized net capital gains and losses for the year and any net capital loss carry over you may have from prior years. This will help you anticipate factors that will impact your 2010 tax bill.
• If you have a net realized capital gain for 2010 and no carry over loss to offset it, consider harvesting some losses from your taxable portfolio to mitigate your tax bill. Remember, long term losses must first be used to offset long term capital gains. Further, short term losses must first offset short term gains. After this netting out process, any remaining long term loss can be used to offset short term gains.
• If in your probability assessment you have determined that the tax cuts are not likely to be extended, consider proactively selling long-term investments with embedded gains and subject yourself to the maximum 15% capital gains rate as opposed to the 20% rate you may be subject to in the future. In fact, if you are in the 10% or 15% marginal income tax bracket in 2010, you can recognize long term capital gains tax free.
• Mutual funds often distribute capital gains at the end of the year, which can catch people unaware. The owner of a mutual fund can contact the mutual fund company and ask what they anticipate the distribution will be. Once you have this information, you can take the appropriate steps to mitigate the tax liability.

Estate Taxes

Another effect of the Economic Growth and Tax Relief Reconciliation Act of 2001 is that the estate tax was completely phased out in 2010. If there are no modifications to this law change, any estate, regardless of size, can be passed to heirs completely tax free. The estate tax is scheduled to return in 2011. However, while there is no estate tax, inherited property no longer receives a step-up in basis, exposing those assets to potentially large capital gains taxes when sold. Watch for adjustments, as these laws are likely to be altered soon.