Timeless Investment Truths- Part One Tax Professionals

The market is trying to make some small gains for ‘Da boys on Wall Street”. At the end of every quarter, (bonus time for da boys) all stops are pulled out to insure a positive quarter- which puts money in their pockets short term- usually not in yours. Earnings season in the US doesn’t begin until April 11th, so things should work out well for the traders and maybe not so well for some investors as we head into the season. MCS has decided to put out a few timeless blogs on investment truths for our readers. Since we are in tax season, we will begin with a few items investors should understand prior to the annual visit to their tax professional:

  • Tax professionals rarely like to ‘tell’ their clients they owe additional taxes. Thus, they often minimize the value of paying taxes on investment profits. Future blogs will discuss holding stocks for years or even decades without locking in a gain, (or loss); but suffice it to say, if you made a profit in the stock market- THIS IS A VERY GOOD THING. In a time period when many investors still have carry forward losses from the meltdowns of ‘00 and ‘07, we are dumbfounded when tax professionals minimize investment gains.
  • Tax professionals seldom educate their clients on investment fees. The following information is from a March 4, 2015 article in US News and World Report:

“Mutual fund fees are often discussed, but not fully appreciated by many investors. The ultimate cost of owning a fund is far greater than what meets the eye. This is primarily due to two reasons. First, only about a third of the total cost is reported by the expense ratio. Other hidden fees can more than triple this explicit expense. Another factor often missed is the power of compounding fees, and even small changes in expense can become material over time. For example, the average mutual fund expense ratio in 2013 was 1.25 percent according to Morningstar, which may not seem like much. Now, here’s the kicker. Including all of the hidden fees associated with mutual funds, the total cost of ownership is estimated to be over 4 percent annually for a taxable account, according to a 2011 Forbes piece, “The Real Cost of Owning a Mutual Fund”.

Another good read on mutual funds, which may assist in unraveling the mystery of mutual fund costs, (including load and no-load funds) is the book: “The Great Mutual Fund Trap”. At one time or another, most of us have invested in mutual funds during our lifetime, either in our own accounts or through our 401K, thus we owe it to ourselves to be fully educated on these products.

Keep in mind that a mutual fund primarily tracks a segment of the market like Large Cap stocks or Bonds, which is mostly long only- or dependent on the market going up. Mutual funds are typically fully invested and do not have a preservation or protection piece, but they come with an approximate 4% total cost of ownership per year that is not tax deductible.

Most investors use an advisor and do not purchase their own funds. Advisory fees usually run about 1% and they are tax deductible. Management fees are also deductible in some cases, including for Separately Managed Accounts, which is why many astute investors use these ‘SMA’ accounts instead of investing in mutual funds. Two investors could be invested in a similar product- one through a mutual fund and one through a separately managed account- creating two different tax deductions: Investor one can only deduct his advisory fee, not his management fee in a mutual fund. Investor two can deduct his advisory fee and his Separately Managed Account Management fee.

For Hedge Fund investors- you receive a K-1. A Schedule K-1 is slightly different depending on whether it comes from a trust, partnership or S corporation. The United States tax code allows certain types of entities to utilize pass-through taxation. This effectively shifts the income tax liability from the entity earning the income to those who have a beneficial interest in it. The Schedule K-1 is the form that reports the amounts that are passed through to each party that has an interest in the entity such as a Hedge Fund. The ability to deduct these costs is beneficial- which is one of the main reasons most wealthy families invest in Hedge Funds. Simply put-the ability to deduct the fees for all parts of investment management is just one of the advantages.

  • Most tax professionals are knowledgeable in the area of taxes- but not in finance. Most are unaware of their client’s long term financial plans. They usually look at each return year, and compare the prior year to determine how certain items affect that particular tax return. When tax professionals, advisory/money management teams and the family attorney (if there is one) all work together, a client can expect the best results.

In closing, the economic data continues to be weak while the upcoming earnings season is starting with negative earnings growth for the market at large. Even Janet Yellen addressed the weak economy in her speech yesterday. She has now moved to a dovish stance based on the economic data to date; her assessment of the economy is cautious.

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