Investment returns – does tax really matter?

By Ashley Davis

​You bet it does. You see, we have a habit of spending our money in after-tax dollars. So if we are relying on our investments to fund our lifestyle in retirement those investments will need to work harder if our return is being eroded away by excessive amounts of income or capital gains tax along the way.

An example of this is a managed fund with an actively traded portfolio, where the fund's securities are bought and sold regularly throughout the year. This high turnover, in a good year when the market is going up and profits are being made, will likely produce substantial capital gains that are taxable to the investor.

Unless such an investment is held within a tax-free or low-tax structure like superannuation, the net return received by the investor could be much lower than the number published in magazines and research reports. This is because all net capital gains triggered by an investment manager will be distributed to the investor at the end of each year and, depending on the investor's tax rate or the structure which holds the investment, a lot of tax could be payable.

One easy way to reduce tax would be for a manager to wait at least 12 months before selling an asset, which would halve the taxable capital gain distributed. Unfortunately, many active managers are more concerned with turning over securities when their models tell them it's time to buy or sell.

Another downside of a portfolio with high turnover is that when markets have bad years, the frequent trading in securities may produce large capital losses. Sometimes those accumulated losses are large enough to be greater than the investment income eared within the fund (eg, dividends), which means the fund cannot pay any income distributions to investors for that year.

A way to avoid this is to invest with a more "market-like" exposure, where the portfolio is broadly spread across the market and not traded too heavily. This produces income levels which are very similar to the overall market and with fewer tax headaches as well. Such an approach may be suitable for investors outside superannuation where tax could be an issue, and a more actively traded method could be utilised within super if the investor favours that approach.

Either way, proper planning before investing any money is the best way to ensure the right investments are held in the most appropriate structures, maximise the efficiency of the portfolio and give the investor the best chance of having a successful long-term investment experience.

To learn more about Ashley, view his online profile.

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