Many people have different types of investment accounts, each with its own manager. We have found, however, that having one manager for all of your accounts can not only eliminate knowledge gaps and unnecessary complexity, but can also result in tax benefits. And for investors particularly, taxes are something to pay attention to. They can seriously impact your long-term returns – and your overall net worth.
A quick overview: generally there are three different types of investment accounts. These include:
- Taxable – These include individual, joint, trusts and custodial accounts. Any gains realized, dividends and interest paid in these accounts will be taxed in the year they were earned
- Tax-deferred – These are retirement accounts, such as 401ks, SEP IRA, SIMPLE IRA, and traditional IRAs. Money goes into these accounts pre-tax, and taxes are not due on principal or earnings until they are withdrawn. As with all retirement accounts of this type, there are tax penalties for early withdrawals.
- Tax-exempt – Roth IRAs, ROTH 401ks, HSAs (when used for health expenses) and some 529 plans make up this group. Money is contributed after-tax, but earnings and dividends accrue tax-free, though they are subject to early withdrawal restrictions.
Two key areas where investors benefit most from having one manager for their accounts include: 1.) tax location, and 2.) tax-loss harvesting.
The practice of strategically placing investments in different types of accounts to maximize their after-tax returns is called tax location. The benefits of tax location have been well-cataloged, with studies pointing to a boost of 20-plus basis points per year on average. This extra return doesn’t require any change in your mix of assets, just some attention as to where you put them.
Most people today have multiple investment accounts to manage as they work towards retirement. In addition to savings and brokerage, it’s common to have a 401k plan, a Roth IRA, and a rollover IRA from a previous job. Each of these have unique tax characteristics, and not all accounts are suitable for every investment. Placing your carefully chosen assets in the wrong account can take a big chunk out of your expected returns.
When you have one manager for these different accounts, then tax location becomes a powerful technique that helps you maximize your returns; however, this method can be difficult with multiple managers of your accounts. Unless you can tell one manager to handle certain asset classes – e.g. corporate bonds, dividend-paying stocks and/or real estate – in an IRA and another manager to buy things like muni bonds and growth stocks in a taxable account, the tax location strategy is difficult to pull off. Most managers tend to buy multiple types of investments – some stocks here, some bonds there – in order to be diversified.
At Personal Capital, tax location is integral to our overall tax management approach. We automatically direct purchases of high-yielding tax-inefficient assets like REITs and high-yield bonds to available IRA accounts, while housing more tax-efficient assets like equities in taxable brokerage accounts. This combination of sheltered earnings and tax efficient growth can result in a smaller bill at tax time each year, and more money available for your retirement.
Tax Loss Harvesting
Tax loss harvesting is a technique you can use to proactively harvest available losses to offset gains by selling depreciated securities. A portfolio of stocks is likely to have both winners and losers in any given year. If left untouched, this can lead to material portfolio deviations. Tax loss harvesting creates an opportunity to rebalance the portfolio back to model weight—you can claim losses and simultaneously pare down winners with large embedded gains. Capital losses are first used to offset capital gains, and if capital losses exceed capital gains, you can offset up to $3,000 of other income. The end result is a higher net after-tax return
There are a few caveats: First, if you plan to repurchase the same, or substantially identical, security within 30 days after selling at a loss, your trade may be deemed a “wash sale.” Second, you can’t buy a new security (within 30 days of sale) that is essentially the same as the security you sold.
If you are using different managers for your accounts, you run the risk of violating the wash sale rule when using tax loss harvesting to your benefit. This is a classic case of the left hand not knowing what the right hand is doing. If, say, the manager of your individual account sells a certain stock for a loss and your IRA manager buys back that stock within the 30-day timeframe, then you’re in violation of the wash sale rule through no fault of your own.
At Personal Capital, we use tax loss harvesting to help keep you more efficient with your taxable investment accounts. Tax loss harvesting has helped most of our clients harvest enough losses to offset all gains incurred and even hit the $3,000 maximum deduction amount.
At the end of the day, there’s a certain amount of efficiency and balance to having one manager for all of your investment accounts. When it comes to taxes, this could also mean more money you take home, which, at the end of the day, is what really matters.
Michelle Brownstein, CFP®
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