Last week I was meeting with new clients doing a review of their investment portfolio. I was amazed that two people in their mid-thirties had been able to amass an investment portfolio of almost $650,000. They had several factors that contributed to them being able to save so much. No student loan debt which allows them to focus on daily expenses, both are above average earners, no children, a long work history going back to their mid-teens, and a commitment to saving and investing from the time they started working. They have what I call a budget framework that they follow and they also seemed to understand proper asset allocation and had a very good mix of asset classes (though I had not done a Risk Assessment for them yet, it seemed to be on target). As I was congratulating them on their success with their savings, I made the comment “the only thing I would have tried to do differently is made an attempt to put some of the assets in different account types, but we still have a lot of time to adjust this”. The husband, Jake, then looked at me with a funny expression and asked, “What do you mean by that exactly?”
I answered him by explaining that the old way of thinking about investments was that asset allocation was the most important aspect of a portfolio’s design. A “proper mix” of asset classes based on an investors risk profile should, in theory, reduce the overall volatility of the investments while yielding a higher risk-adjusted rate of return. But as tax advantaged accounts started to pop up (IRA, 401k, Roth IRA, Roth 401k), adding to the already available taxable brokerage account and tax-deferred annuities, tax professionals that understood the workings of the tax code, and the ramifications of the new account types to investors, began to play with placing certain asset types in different account types based on how they are taxed. Add to this the number of available alternative asset classes such as REIT’s and Commodities having a proper asset allocation and location strategy can maximize after-tax returns.
Keep in mind that most asset allocation decisions are generally based on long-term expected returns that are based on prior history and not more reliable assumptions for shorter term returns. These are long ranging decisions and it is not recommended that people try to time the market by changing positions back & forth on a regular basis. It is also not recommended that when rebalancing a portfolio, it is done from taxable account positions that can cause excessive taxable gains unless you can capture a capital loss or have saved up capital losses. Also, it is not recommended that rebalancing occurs by selling from anything that could cause excessive transaction fees that will eat into an overall return. So, an advisor should also consider transaction costs along with taxes when constructing a portfolio. As an example, Large Cap Stock ETF’s generally have a lower tax burden than Large Cap Stock mutual funds because they do not pass through capital gains to the account holder on an annual basis, thus being a better choice for taxable accounts. Large Cap ETF’s. if chosen from a “preferred list” could also be transaction free. A Win/Win!!
Having said that, from an investment standpoint, the advisor needs to also factor in such things as municipal bond returns (as they are tax-free) vs. taxable bond returns. If muni bonds tax equivalent yields are better than after-tax bond rates of return, it makes sense to hold muni bonds in the taxable account and the taxable bonds in a tax-deferred account such as an IRA.
Tax inefficiency typically means taking distributions that are taxed as ordinary income with lower asset appreciation. To the extent possible, these assets should be held in the Traditional form of an IRA. This produces the benefit of lower RMDs at age 70 ½ and beyond as well as a lower income in respect of a decedent. Also, the point that building a higher balance in the IRA means a higher value in the portfolio doesn’t consider that we’re looking at the total portfolio and not just the IRA which eventually will get taxed at ordinary rates regardless of who takes the distribution (spouse, children, etc.).
As mentioned earlier, gains that are recognized by an investor after selling a position in a taxable account can be offset by tax loss harvesting strategies. It is recommended that investors utilize a “building capital losses for future use” strategy. This is done by harvesting tax losses regularly, using the $3,000 per year that is allowed to offset ordinary income and then carrying over the excess to use in future years or more importantly when rebalancing an out of balance investment portfolio where the assets in the taxable account are the assets that need to be sold. Thus, utilizing this strategy will allow for rebalancing in taxable accounts at a lower tax rate.
Because Roth IRAs never get taxed again once the funds are in the account (there could be penalties though), they are typically the last accounts that should be liquidated by the investor during retirement and thus it is recommended that higher growth potential investments be placed in Roth’s, especially during the wealth accumulation stage. Of course during retirement an investor wishes that every invested asset they have could somehow be magically transferred into a Roth IRA, but that is not possible to do without causing a lot of pain (Taxes!!). Remember that Roth assets are not included in AGI numbers so having a plan where a majority of a draw down is taken from Roth accounts should help with portfolio longevity because you will not need to draw as much from a Roth to meet Cash Flow needs in retirement as you would if you take funds from a Traditional IRA (again, because of taxes!!!).
So, which account types and asset classes should go together? This is an interesting question and a question that has been debated for some time and is being still being debated regularly. There is not an overall consensus right or wrong answer, but there is some common framework. Most experts have ranging opinions on which assets belong in which types of accounts. Some will say that all bond holdings should be held in IRA if it can be pulled off. Other say that each account types should have a mix of all asset classes regardless of what kind of account it is. Why is there such a disparity between schools of thought? There are many reasons. Advisor biases, advisor lack of understanding of the tax code, the complexity of the tax code, etc. etc., etc. I could go on for the rest of this piece.
In a recent article on Fidelity.com (https://www.fidelity.com/viewpoints/investing-ideas/asset-allocation-lower-taxes) they do a good job of explain investment type tax inefficiency and where an investor can optimally place their assets. This is explained in the chart below that was in the above mentioned article.
This chart does a great job of graphically explaining this concept. I have explained to the clients that I work with that it is our goal moving forward to achieve a similar framework with their retirement assets. But I like to go a little further. For example, I like to make sure that those funds that historically outperform over the long term (e.g. Small Cap) will be placed in the Roth account as this account will be used last (thus a long term investment horizon). I also usually recommend Large Cap Stock ETF’s for taxable account positions.
There is no way to know for sure what tax rates will be on each investment you own moving forward but generally we can assume the following:
Bonds, except for tax-free municipal bonds and U.S. Saving Bonds, are not tax efficient because they generate interest payments that are taxed as ordinary income which have the highest tax rates. Potentially higher returning, more volatile types of fixed-income investments such as high yield bonds (junk) are the most tax inefficient.
REITs are also not very tax efficient. That is because they are required, by law, to pay out at least 90% of their taxable income, and, unlike other equities, this income is generally taxed at higher ordinary income rates.
Individual stocks though are tax efficient. This is due to qualified dividends and capital gains on the sale of stocks held a year or more being currently taxed at a top federal rate of 23.8% (this includes the highest long-term capital gain rate of 20% plus the 3.8% Medicare surtax on net investment income). Investors with lower taxable income could pay rates of 18.8%, 15%, or even, 0% if they do quality tax planning integrated with a functional withdrawal strategy. Equity-based exchange-traded funds (ETFs) are usually taxed like stocks. However, the phase out range of itemized deductions could drive the marginal tax rate you pay on stocks somewhat higher if you’re a high-income earner.
Stocks mutual funds are more complex. While stock index funds are generally quite tax efficient, many actively managed stock funds are not tax efficient because of high turnover rates. They will distribute short-term capital gains, which are taxed at the higher ordinary income tax rates. Add to this the fact that most actively managed higher volatility funds (small cap and international funds) are usually liquidated first by investors in times of market decline there could be a double whammy regarding returns and taxes even if an investor did not personally sell.
In summary, focusing on asset allocation AND asset location could lead to higher future after tax returns of an investment portfolio.
At Olympia Ridge we help people by designing a proper asset allocation and location strategy.
Olympia Ridge, LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.