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 bite out of your expected returns!
The practice of strategically placing investments in different types of accounts to maximize their after-tax returns is called tax location, and it’s a powerful technique. The benefits of tax location have been well-cataloged, with studies pointing to a boost of 20+ 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.
In the past year, we’ve seen a few new clients arrive with identical asset mixes in their accounts – regardless of the accounts’ tax status. Unfortunately, it has cost them some return. To help avoid this situation, I’ll explain why tax location works, why it’s advantageous for your portfolio, and how you can go about integrating it into your own portfolio strategy.
Review of Investment Account Types
Your investment accounts fall into three general categories:
1) Taxable: These include Individual, Joint, Trusts and Custodial accounts. Any gains realized in these accounts will be taxed in the year they were earned.
2) Tax Deferred: These are retirement accounts such as 401ks and 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 Money goes into these accounts pre-tax, and taxes are not due on principal or earnings until they are withdrawn.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.
3) Tax Exempt: Roth IRAs, Roth 401ks and some 529 plans make up this group. Money is contributed after tax, but earnings and dividends accrue tax free, though subject to early withdrawal restrictions.
Review of Asset Types
Because the cornerstone to effective investing is diversification, you will want to own many different types of assets in your portfolio. A Personal Capital portfolio consists of US stocks, US bonds, foreign stocks and bonds, real estate investment trusts and commodity funds. These assets are taxed in different ways and at different times, and their impact on your portfolio’s returns is in part dependent on where they are located. As explained below, the same asset in your IRA can have a very different after-tax impact if put in your taxable account.
Equities: Taxes depend on how long you’ve owned them. Gains in stocks held one year or longer are taxed at a preferential long-term rate, generally 15%. If you are in the 15% tax bracket, you may not have to pay any capital gains taxes, and if you are in the very highest tax brackets, rates increase to 20% compared to 39.6%. Short-term gains are taxed as ordinary income. Qualified equity dividends are also taxed at the 15% level.
Bonds: Taxes on bond capital gains are the same as for equities, but interest payments are taxed as ordinary income. Therefore, the tax efficiency of the bond depends greatly on how much it pays out in interest. The actual tax paid depends on the type of bond. Treasuries are only taxed at the federal level, and Municipal bonds are not taxed at the Federal or State level, as long as you live in the state where they were issued. Corporate bonds have no tax free provisions.
REITs: Real Estate Investment Trusts are required by the IRS to pay out at least 90% of their income to shareholders every year, to avoid being taxed at the corporate level. These payouts are then taxed as ordinary income, though the REIT may designate some portion as qualified dividends or return of capital.
Commodities: Commodity funds fall into two basic categories. Those that hold physical assets like precious metals and those that own futures contracts to track commodity prices. Precious metal investments are considered “collectables” and are taxed at ordinary income rates of up to 28% for long term holdings and 35% if held less than a year. Funds that hold futures are usually structured as limited partnerships and taxed at a combination of long and short term rates. They also are taxed on unrealized gains annually and issue a K-1.
Looking at this list, it’s clear that some assets carry a larger tax burden than others. Two factors are key in determining tax sensitivity. One is the nature of the asset’s returns – whether it’s capital gains, dividends or income. The other is the size of those returns. As expected return grows larger, so does the tax effect in your portfolio.
Tax Location: Placing the Right Assets in the Right Accounts
Having laid out the various types of assets and accounts, we can now distinguish which investments go where:
- Any asset which has a high expected return and is tax inefficient should be sheltered in a tax deferred or tax exempt account. These include REITs, high yield bonds, and stock funds with a high degree of short-term turnover.
- Assets that are high growth but tax efficient, such as long-term stock holdings and equity index funds, should be added to a taxable account. Dividends and capital gains from these funds are tax advantaged, and the funds themselves can be used for tax-loss harvesting, further lowering your eventual tax bill.
An Example: Failure to Tax Locate
As I mentioned earlier, one thing we often see in new client accounts is an identical asset mix, regardless of the accounts’ tax status. Some people set their accounts up in this fashion so that the pre-tax returns between accounts will be roughly equal on their statement, but in doing so they are costing themselves money in the form of extra taxes each year.
For instance, imagine that an investor purchases $10,000 of a bond fund yielding 10% and $10,000 of a stock index fund returning 10%. Say he’s in a 35% tax bracket. In the first scenario, he puts half of each asset in his IRA and taxable accounts. In the second scenario, he tax locates and puts the bonds in his IRA and the stocks in his individual account.
In either scenario, the investor ends up with $2,000 in pre-tax gains at the end of the year. However, in Scenario 1 the individual account will owe taxes on the bond income of $500 x 0.35% = $175. Since the gains on the stock index fund are unrealized, they are not taxed. The after-tax year-end gains between accounts will be $1825.
Conversely, in Scenario 2 the $1,000 in bond income is sheltered in the IRA, while the stock fund gains $1,000 in the individual account. In this scenario, no taxes are due in the individual account until the stock fund is sold, and even then will be at lower long-term capital gains rate of 15%. The after-tax year-end gains are therefore $2,000.
The takeaway here is obvious. The same two assets in identical amounts can result in after-tax year-end gains of either $1,825 or $2,000, simply depending on where they’re placed in the portfolio. But of course, taxes will inevitably come due during withdrawal, at which time one can execute a variety of maneuvers to keep the tax bill as low as possible.
Academic studies are also solidly in support of a tax location strategy for personal investments. For instance, “Asset Location: A Generic Framework for Maximizing After Tax Wealth”, by Gobind Daryanani and Chris Cordaro, finds that a tax location approach which shelters high-yielding tax-inefficient assets can outperform a pro-rata allocation by an average 20 basis points per year.
Another study, “Alpha, Beta and Now…Gamma” by David Blanchett and Paul Kaplan puts the benefit at 23bps on average. These estimates of outperformance were borne out of Monte Carlo simulations over a wide range of client profiles, portfolio additions and withdrawals, and tax law changes. They were found to be very robust, with Daryanani reporting that the tax location benefit was more than 10bps per year even at the bottom 25th percentile. The persistent outperformance shows the tax location strategy to be a relatively variance free way to increase returns in a portfolio.
The Personal Capital Approach
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 the taxable brokerage. This combination of sheltered earnings and tax efficient growth will result in a smaller bill at tax time each year, and more money available for your retirement. Which is, after all, the goal.
Photo: Retirement life in Balandra Bay, Mexico.