THE BENEFIT OF TAX DEFERRAL AND STEPPED-UP BASIS IN TAXABLE
INVESTMENTS

By William E. Fender, JD, CPA

Tax deferral has long been recognized as a desirable strategy because of the time value of money. An economic benefit received today (i.e., taxes not paid) has greater value than an equal benefit received at some point in the future. Conversely, a cost incurred at some point in the future (i.e., taxes paid) is less detrimental than an equal cost incurred today. A cost that can be deferred and never paid is even better.

While most investors understand the benefits of tax deferral through a tax deferred investment vehicle, such as a 401(k) retirement plan, many may not appreciate the importance of deferring taxes in their taxable investment portfolios. Taxable portfolios are investments subject to current taxation on interest, dividends, and capital gains. In addition, many investors may not appreciate the significant benefit of stepped-up basis.

An "Interest-Free Loan"

Unrealized gains in an investment portfolio are the capital appreciation that has not been cashed in. Untaxed capital appreciation creates a deferred tax liability, i.e., taxes deferred until the sale of the appreciated asset.

Deferred taxes are frequently called an interest-free loan from the U.S. Treasury. From this loan an investor benefits in two ways. First, the investor can earn income on the full amount of the invested principal, including the deferred taxes, until the appreciated asset is sold and the tax paid. The income generated may be subject to tax, but more invested principal equals more pre-tax income which equals more after-tax income. Second, the investor benefits from capital appreciation on the full amount of the invested principal, including the deferred taxes. Ultimately the appreciation may be taxed if the asset is sold, but there will still be a net benefit to the investor because of the growth on the full principal.

Stepped-up Basis

Holding assets until death results is a step-up in tax basis to fair market value at the time of death. Tax deferral on the unrealized and untaxed appreciation becomes tax forgiveness. The real value of a taxable portfolio at any point in time is the amount that would be realized on the sale of the portfolio, after capital gains taxes and costs, plus the present value of the capital gains tax liability that would be eliminated with a step-up in basis at death. For a younger investor, the present value is small. For an older investor, the present value is higher, indicating the importance of maximizing deferral to benefit from stepped-up basis.

Older investors may want to maintain control over their investment assets to protect their financial security in the face of future unknowns. But the reality is that many investors will not spend down their entire net worth during their lifetime and will leave substantial estates to heirs. Maximizing unrealized gains and tax deferral is an enormous benefit for the investor who will transfer a substantial estate to heirs.

In addition, the strategy of incorporating the possibility of stepped-up basis into investment planning results in significant benefits to investors, even if the investor doesn't hold the assets until death.

The Benefits of Deferral

The Exhibit demonstrates the benefit of tax deferral and stepped-up basis. The exhibit assumes an initial investment of $1 that earns a 10% annual compound return for 20 years. It shows the impact of various deferral scenarios as follows:

Line 1: Growth of $1 assuming the annual 10% return is fully taxed every year as long-term capital gain.

Line 2: Growth of $1 assuming the investment appreciates 10% per year for three years before the investment is sold, the appreciation is taxed as long-term capital gain, and the balance is reinvested.

Lines 3-5: The same calculation as line 2 for 5, 10, and 20 years.

Line 6: Growth of $1 at 10% per year for 20 years with no sale calculation because it is assumed to have received a stepped-up basis.

Column 2 shows the amount that $1 would grow to under the various assumptions listed in column 1. Comparing the stepped-up basis calculation (line 6) to all of the scenarios illustrates the dramatic impact of the step-up benefit. The stepped-up basis calculation results in an investment return that is 215% higher than the annual capital gains taxation scenario. ([6.73-1.00]/[3.66-l.00] = 215%)

Column 3 shows the after-tax annual compound return for the 20-year period for the various scenarios. Comparing column 2 to column 3 illustrates that small differences in the annual after-tax rate of return can compound into very large dollar differences over long time periods.

Column 4 shows the effective tax rate for the various deferral scenarios. The effective tax rate shows the benefit of deferral over longer periods and the tremendous benefit of stepped-up basis. The reduction in the effective tax rate becomes proportionately larger as the holding period increases. Note that the effective tax rate is reduced to 0% as a result of the stepped-up basis.

Equivalent Pre-Tax Rates of Return

Column 5 shows the pre-tax rates of return that would be required under each of the various scenarios on lines 1 through 5 to equal the ending value of $6.73 (line 6, column 2). For example, an investment that is fully taxed as capital gain every year would have to earn a 14.9% pre-tax annual compound return to equal the results of an investment that earns a 10% annual pre-tax compound return and receives a stepped-up basis in year 20.

Some might argue that active investment management can overcome the detrimental effect from taxable portfolio turnover. Column 5 demonstrates the significant hurdle active management must overcome. For example, to achieve the $6.73 ending value of the 20 year compounding and step-up in basis, the 3 year compounding and sale scenario (perhaps a generous comparison considering the turnover in most mutual funds and portfolios) would have to earn a 44% higher pre-tax return compared to the after-tax return (i.e., [14.4% - 10.0%]/10.0% = 44%) every year for the 20 years. In an investment environment where investment mangers strive to earn value-added returns of 1-2% over benchmarks, is it likely that a portfolio can earn substantially greater pre-tax returns above the after-tax returns every year for the 20 years?

The scenarios in Exhibit 1 are clearly extremes, e.g., 100% annual turnover, 20 years with no turnover, etc. In a more realistic example, there would be some dividend distributions that would adversely impact the calculations because of higher ordinary income rates and reduced deferral. In addition, a more realistic example would probably have different levels of annual portfolio turnover, rather than "cliff" liquidation, taxation and reinvestment. Nevertheless, the general thesis that deferral and stepped-up basis is critically important is clear and indisputable.

Design Priorities

Every investor should begin by designing an investment portfolio based on the three most important variables affecting the risk/reward profile--investment time horizon, investment objectives, and risk tolerance. After the optimal portfolio has been designed based on these inputs, it should be fine-tuned to optimize its tax efficiency.

Whenever possible, investors should prioritize as follows in the design, implementation, and management of tax efficient investment portfolios:

* Favor capital appreciation over ordinary income.

* Favor capital appreciation deferred
over capital appreciation taxed annually.

* Favor capital appreciation deferred over longer periods to capital appreciation deferred over shorter time periods; the longer the better.

* Design the portfolio with the possibility of stepped-up basis.

Who Should Plan for Stepped-Up Basis

Any investor who may leave a substantial estate for heirs should consider the possibility of stepped-up basis in designing a portfolio. Whether an investor may leave a substantial estate is a function of many variables, including age, current and projected net worth, future earning capacity and standard of living. Obviously, high net worth individuals have a significant opportunity to plan for stepped-up basis.

Note that a stepped-up basis could be a benefit to an investor even if his or her estate would not be subject to estate taxes. An estate not large enough to incur estate taxes might, nevertheless, have a large amount of low basis investment assets that would benefit from stepped-up basis.

Some investors may chose to live off withdrawals from qualified retirement plans, even if it means taking distributions greater than the minimum required, so that they can structure their taxable investment portfolio for stepped-up basis. Qualified plan distributions will be taxed as ordinary income no matter who receives them or when they are received. The taxable investment portfolio can be designed for capital gain, if sold by the investor, or stepped-up basis, if received by heirs. Some might argue that withdrawals from qualified plans reduce the opportunity for tax deferred growth. The response is that the taxable investment portfolio can be designed for tax advantage (i.e., from capital gain) and
tax deferral (i.e., from
low turnover), or tax
forgiveness (from stepped-up basis).

How to Implement for Deferral and Stepped-up Basis

The ideal tax-efficient investment would have the following characteristics:

* It generates capital appreciation only, no dividend or interest income.

* It enjoys steady long-term appreciation, at least comparable to broad market indexes, with limited volatility.

* Its turnover is controlled by the investor.

* It generates capital gains upon sale or gets a stepped-up basis upon inclusion in the investor's estate.

Since it would be very difficult to create an investment portfolio with these characteristics, the objective is to get as close to the ideal as possible. Whenever an investor is at a decision point that involves the possible sale of an appreciated asset, the investor should carefully weigh the impact of the loss of deferral and tip the scales in favor of not selling unless there are compelling reasons to sell.

It should be recognized that a steadfast focus on minimizing turnover will have other implications for the investor. To the extent that turnover is minimized, risk (i.e., volatility) may be increased because the asset allocation initially employed will be altered as different asset classes perform differently over time. Since the time horizon for the portfolio is long-term, by definition, the year-to-year risk profile of the portfolio may not be a concern. The cost of taxes incurred to sell assets in a portfolio
may be greater than the loss that
would be incurred as a result of a sale in a temporarily depressed market,
further encouraging a low turnover approach.

Maximizing the Benefit of Tax Deferral

Following are some strategies intended to maximize the benefit of tax deferral in a taxable investment portfolio.

Minimize Portfolio Turnover. It is far more important for taxable investors to be sensitive to taxable turnover in the low ranges than in the medium and high ranges. Once the low ranges of turnover have been passed, nearly all of the tax damage has already been done. One author found that at a relatively low turnover rate of 25% per year, portfolios incur fully 80% of the taxes that would be generated at turnover levels of 100% or more (See column 3 of the exhibit, where the after-tax rates of return experience proportionately greater increases as the holding period lengthens beyond 10 years). The author also found that an investment portfolio had to generate two to three percentage points more in pre-tax returns every year relative to a comparable index to offset the consequences of active trading, even at low levels of portfolio turnover. (See column 5 of the exhibit for similar results.) To maximize deferral, investors should focus on significantly longer holding periods.

Portfolio reallocation strategies are performance enhancement techniques designed to improve total return, and include strategies like market timing. These strategies involve relatively frequent transactions and realization of gains. The ability of investors to time the market successfully has been widely questioned. Combining this with the significant negative impact of turnover on after-tax returns indicates that investors should not use portfolio reallocation as an investment strategy.

Analyze Rebalancing Decisions. Portfolio rebalancing strategies are used as risk control measures and are designed to keep asset weightings in an investment portfolio close to their strategic targets. Taxable investors who widen rebalancing ranges increase after-tax total returns for two reasons. First, fewer rebalancing transactions result in lower turnover and therefore greater tax deferral. Second, wider ranges result in higher percentages of equity asset classes in the portfolio over the long run.
Wider rebalancing ranges may,
however, increase portfolio volatility because of the higher percentage of
equity asset classes.

Rebalancing ranges should be widened for greater tax efficiency. One study examined various rebalancing ranges and quantified the frequency of transactions generated, the increased after-tax returns and the increased maximum one-year loss incurred. (It used a 60% equity and 40% fixed income portfolio that was rebalanced at various range thresholds using simulated returns over 15-year time periods. The study found that at the 8% rebalancing threshold, the simulation generated an average of .2 transactions per year, which equated to an effective holding period of over 31 years. At the 8% rebalancing level, the increase in annual after-tax returns compared to a continuous rebalancing strategy was .21%. Finally, the study found that the increase in maximum one-year loss at the 8% rebalancing threshold, compared to a continuous rebalancing strategy, was 1.35%. For the investor who is focused on long-term deferral and/or possible stepped-up basis, rebalancing ranges should be significantly widened or eliminated entirely.

Carefully design tax efficient portfolio. The investor should also consider the use of passive management, i.e., funds. In the more efficient segments of the investment portfolio (e.g., domestic large cap equities), index funds may have the advantage of equaling or exceeding active management while minimizing taxable distribution to reduced portfolio turnover.

In recognition of the growing awareness that a passive or indexed approach to equity investing frequently outperforms a large percentage of active managers on a pre-tax basis, and that it can outperform an even higher percentage on an after-tax basis, at least two mutual fund sponsors have created equity index funds that are "tax-managed" to provide even better after-tax performance than a pure index fund.

Index funds realize capital gains for three reasons: 1) Purchases and sales that represent changes in the composition of the underlying index, 2) share repurchases by the companies in the index and 3) net redemptions by the fund's shareholders. To increase tax efficiency the tax managed index fund sponsor strives to minimize realized capital gains that are distributed to shareholder.

Diversify without selling. Investors with significant holdings that are highly appreciated with a low basis face a unique investment problem. On the one hand is the desire to hold the assets, avoid capital gain taxation and maximize deferral and maximize the potential for stepped-up basis. On the other hand is the desire to diversify an investment portfolio to decrease risk and possibly increase investment returns.

In some instances it may be necessary to temporarily raise capital or restructure a portfolio for current needs, and yet the investor may desire to leave the investment portfolio intact because it meets long-term strategic objectives. How can the investor leave the underlying portfolio in place without incurring capital gains? One possible solution is to borrow against the investment portfolio instead of selling it and generating capital gain. The investor should analyze the costs of borrowing and compare them to the significant tax cost that might be generated from changes in the mix of a portfolio and the loss of deferred taxes, especially if the change is not long-term in nature.

To deal with a concentrated equity portfolio, investors may want to consider--

* family gifts and asset protection strategies (e.g., gifting, trusts, intrafamily loans, family limited partnerships, and grantor retained annuity/unitrust trusts).

* charitable giving strategies (gifts of appreciated securities, charitable remainder trusts, charitable lead trusts, charitable IRA's).

* portfolio diversification strategies
(borrowing with portfolio as collateral, short sales against the box, equity exchange fund).

Develop Low Basis Security Strategy. In some cases, however, it may not be possible to achieve diversification and risk reduction without selling the appreciated assets. When capital preservation or risk reduction are the primary concern and low-basis securities represent a concentration in a portfolio, the manager may consider a plan of selling a portion of the holdings over a defined time horizon or a strategy designed for reducing risk.

Investors should consider the following variables in evaluating the best course of action in dealing with a highly appreciated, low basis concentrated equity
position:

* Probable investment time horizon,

* Projected return and risk of existing investment,

* Net after-tax proceeds from sale of appreciated asset, and

* Projected return and risk of a diversified portfolio created with after-tax
proceeds.

Minimize the amount of taxable gain on sale. Turnover by itself is not useful for predicting after-tax performance because it is not necessarily linked to the level of taxable distributions. Turnover can be used to realize capital losses as well as capital gains. Investors who sell losers quickly and hold winners may have high turnover, but low net realized gains.

Minimizing a tax liability from an investment portfolio begins with wise investment purchase decisions. Investors should avoid purchases of investments before distributions of dividends or capital gains. When evaluating mutual funds or separate account investment managers prior to a purchase, investors should consider historical dividend and capital gain distributions, portfolio turnover, short vs. long-term capital gains, after-tax returns compared to pretax returns, unrealized gain in a mutual fund, and the use of tax lot accounting to minimize capital gains distributions (see below).

There are also strategies for minimizing the impact of gains on the sale of investments. Successful tax management begins by keeping accurate records on cost basis of shares held, including the impact of reinvested dividends and capital gains.

Tax lot accounting should be used to minimize the impact of capital gains resulting from sales. When a decision is made to sell specific securities, those with the highest cost basis should be sold first. Securities that are long-term capital gains should be sold before short-term capital gains. Capital losses should be "harvested," when appropriate, to offset capital gains. The loss must be large enough so that the tax savings exceed transaction costs, and the wash sale rule must be avoided. Investments should be sold, when appropriate, before dividend distributions to convert ordinary income to capital gain.

When evaluating mutual funds or investment managers, investors and their advisers should determine if they are using the approaches outlined above to achieve greater tax efficiency.

William E. Fender, JD, CPA, is an investment consultant with Innovest Portfolio Solutions, Inc.

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA\PFS

Contributing Editors:
Alan Fogelman, CPA
Clarfield & Company P.C.