It's a given for many academics and investors that over the long run stocks outperform bonds. But those in the top tax bracket may want to rethink that axiom, especially if they live in states with high income tax rates. That's because for tax purposes, most states generally don't treat stock gains or dividends any differently than ordinary income.
For example, in such states as California and New Jersey, taxable investors face not only the 15% federal tax on long-term capital gains but an additional 10% in state income tax on those gains. So you can see how the equation might begin to change when comparing stocks with tax-free municipal bonds.
Private wealth manager Niall Gannon of the Gannon Group in St. Louis spends much of his time trying to maximize his clients' aftertax returns. According to research he conducted for an upcoming book, Investing Strategies for the High Net-Worth Investor, factoring in just federal taxes (not state taxes) for wealthy investors reduces the 9.15% annualized return of the Standard & Poor's 500-stock index from 1957 through 2008 to 6.62%. Deducting California's 10% income tax reduces the return further, to 5.95%. Worse still, an actively managed mutual fund that frequently trades stocks would produce more short-term capital gains taxed at higher rates. Running the same pretax numbers for a fund with a 100% turnover ratio—an indication that every position in the fund is sold within a year—the after-tax return dropped to 4.59% in California. By contrast, tax-free muni bonds produced an average 5.45% annualized return during the same period with minimal downside risk.
YIELD PREMIUMSGannon has a healthy slug of munis in his clients' portfolios, but that doesn't mean he always favors them over stocks. He has developed what he calls an aftertax calculator that computes an expected aftertax return for each asset class. Currently, because average long-term muni bond yields, at 4.2%, are lower than they often have been in the past, he sees some extra return—what he calls "a risk premium"—to be gained by owning stocks even in high-tax states. "In a state like Oregon, which has an 11% income tax rate, you get a risk premium in stocks of 1.69 percentage points over munis," Gannon says. "In a no-tax state such as Nevada, the risk premium is 2.72 points."
To calculate the premium, he compares the average muni yield with the average stock's earnings yield, which is the inverse of its price-earning ratio. He then subtracts taxes. If the aftertax yield on a stock is higher than the yield on munis, the stock's yield offers the necessary risk premium.
Because of the higher premium in Nevada and other no-tax states such as Florida, Wyoming, and Texas, Gannon thinks it might be worth increasing allocations somewhat to stocks in such states. "I think 10% more in stocks in Nevada wouldn't be unreasonable," he says. (That's 10% on top of whatever an investor's existing allocation is in stocks.) Gannon wouldn't go overboard: The fixed income side of a portfolio, he notes, is meant to keep a portfolio stable and provide steady income.
In an example of how people can draw different conclusions from the same data, Curt Fintel, chief investment strategist at Portland (Ore.) wealth manager CTC Consulting, would recommend the opposite of what Gannon says, given a similar high-tax vs. no-tax scenario. He'd allocate more to stocks in the high-tax state and less in the no-tax one. "If you have a target growth rate in your portfolio, you may need to be more aggressive with stocks to meet your goals in the high-tax state since your aftertax return is less," he says. In one analysis Fintel ran, in order to generate the same after-tax return of 6.75%, his calculations called for an increase in stock exposure from 31% to 48% in the high (10%) income tax state, while the muni allocation fell from 50% to 44%. Meanwhile, because of the additional stock exposure, the volatility of the high-tax portfolio went up—a trade-off to achieve a higher return.
Since wealthy investors' portfolios can be complex, customization is needed to get the allocations right. And because of the intricacies of tax codes, exceptions exist to every rule. Jeffrey Horvitz has written extensively on tax-efficient investing and manages the assets of a single wealthy family—his own—as principal of Moreland Management in Beverly, Mass. Horvitz has concluded that munis serve no purpose in his case. "If you have no or minimal tax deductions relative to your income, munis make a lot of sense," he says. "But most high net worth people have a lot of deductions they use to reduce ordinary income. Real estate taxes, investment and trust fees, and state income taxes are deductible against ordinary income for federal tax filings. If you invest in municipal bonds, you may lose those deductions—and actually have lower aftertax returns."
Gannon says in his clients' cases the benefits of owning muni bonds outweigh the loss of the deductions: "Even if you factor in deductions," he says, "there is still usually a big spread in aftertax returns between municipal bonds and, say, Treasury bonds."
MAJOR EVENTSWealthy investors' state of residence can affect their tax bills in myriad other ways. Two of the most significant have to do with large taxable events such as the sale of a business or retirement. States treat capital gains on the sale of a business as ordinary income. People who sell "a business in Oregon for a gain of $10 million will pay $1 million dollars more in taxes than if they went across the border to sell in Washington, which has no income tax," says Gannon. Meanwhile, 19 states have their own unique estate taxes.
Some investors try to relocate to a zero-tax state to avoid a big tax hit. In fact, many retirees move to states such as Florida prior to withdrawing money from their 401(k)s and being taxed at New York or California rates. But "if you move out of a high-tax state, sometimes the tax laws of the state follow you, and you could wind up in court if you try to avoid paying the tax," warns Thomas Muldowney, managing director of Savant Capital Management, a wealth management company in Rockford, Ill. "Laws vary by state, but typically you have to maintain your new state of residence for three to five years for your previous state's tax laws not to have any impact."
Muldowney is quick to point out that income taxes are only part of the state tax equation. There are also property taxes, sales taxes, estate, business, and corporate taxes. One survey of state tax rates by the Tax Foundation, a Washington think tank, ranks states by their total overall taxes as a percentage of per capita income. In the latest ranking, New Jersey was the highest tax state, collecting 11.8% of its citizens' per capita income in taxes while the average state collected 9.7%. For investors in the top bracket, the numbers would be higher. "If all you wanted was the lowest tax drag, you'd probably move to Alaska, which has an average tax burden of 6.4%," says Muldowney. While his is not a view universally held, he cites "one drawback" to that plan: "It's Alaska."