The Value of Improving Your Portfolio’s Tax Efficiency
Asset location strategies could add significant value to your portfolio over time by increasing tax efficiency. Asset location focuses not just on what you’re investing in from an investment strategy perspective, but where and what types of accounts you’re using to invest your money, all towards the purpose of increasing your after-tax returns.
Let’s say you’ve gone through the process of building out a financial plan, setting some goals and objectives, getting a good idea of your savings capability and your risk tolerance. At the conclusion of this exercise, you’ve determined what your asset allocation strategy is going to be for your investment portfolio. It may make sense for you to put about 20% of your investment portfolio in bonds or other types of fixed income vehicles; another 75% is going to get allocated to stocks or other equities. And then you might have a 5% exposure to real estate or some other type of alternative asset class.
Once you’ve determined your asset allocation, you can drill down a little bit further and start to diversify across several different asset classes. On the fixed income side, we might diversify using Treasury bonds, corporate bonds, and, depending on your income tax bracket, some municipal bonds. On the equity side, we’re going to have some exposure to the U.S. large cap stock market (S&P 500 companies).
But we’re also going to diversify and have some exposure to U.S. small- and medium-sized companies for diversification and growth purposes. We also want to look abroad when constructing our equity portfolio, so there’s going to be some allocation to developed international economies, as well as emerging markets, again, for the purposes of diversification and ultimately adding some growth to your portfolio strategy. Finally, there’d be a sliver of alternative asset classes, such as real estate.
Taxable vs. Non-Taxable Accounts
We’ve first put in place our financial plan, and that’s guided how we’re going to invest our portfolio from an asset allocation strategy standpoint. Most households are going to have a few different types of investment accounts, each with their own different type of tax treatment. And that’s what we’re going to focus on with respect to our asset location strategy. Our taxable investment accounts are going to be non-tax advantaged, non-retirement sort of standard brokerage accounts. These are accounts where you pay tax as you go, so as interest and dividends are earned in the account, you’re taxed on that amount. When you sell assets in taxable accounts for a gain or loss, it’s a taxable event.
Then we have tax-deferred accounts. For example, tax-deferred accounts are going to be our pre-tax 401(k)s and traditional IRAs. These are the accounts where money goes in pre-tax, all of the growth and income and appreciation in this account is going to be deferred for income tax purposes. And then you’re going to pay ordinary income tax on amounts withdrawn in the future.
Lastly, we have tax-exempt accounts, which are the most tax advantageous types of investment accounts because all the income, all the growth, all the appreciation in these types of accounts will never be taxed, provided we follow the rules. These are the most tax advantageous accounts because we’re not going to pay any tax on what happens in here with respect to our investment portfolio.
Implementing an Asset Location Strategy
When you’re looking at implementing your high-level investment strategy from a portfolio perspective, you could take the simple, easy, intuitive approach of saying, “Well, let’s take this allocation, put it in our taxable account. We’ll take the same allocation, put it in our tax-deferred account. And then just mirror that over here in our tax-exempt account.” This would seem to be the most intuitive approach, and it’s the one that most people probably follow when they’re implementing their portfolio strategy across all their investment accounts. However, there may be a better and smarter way. And that’s what the asset location strategy approach focuses on. When you look at asset location, you want to look high-level at what your portfolio strategy is and what each of the different investment assets in that portfolio are to understand what their characteristics are and what their role in the portfolio is.
Then, we want to take those assets and allocate them across your accounts in a way that leverages the different tax features of each of these accounts. In the taxable accounts, the least tax-advantaged, there’s really no tax advantage for money in here. We want to put our most tax-efficient assets in this account, so we might want to have a lot of our exposure to U.S. large cap companies. If you’re getting your exposure here through just basic broad-based index funds — they’re real tax efficient investments. They don’t kick off a lot of income. A lot of the dividends that do pay out are taxed at more preferential qualified dividend rates. You don’t get taxed on any of the appreciation until you sell your investments, so if you’re holding these investments for the long term, it’s a real tax-efficient asset class to have in a taxable account. For the same reasons, you may also include some of your exposure to international developed countries.
Also, if you have some municipal bonds as part of your fixed income strategy, we probably put those in the taxable accounts as well, because we usually don’t pay any tax on the interest that’s generated by municipal bonds.
When we look at our tax-deferred investment accounts, we want to put the most tax-inefficient assets into them. These investments are the ones that generate the most income each year, each quarter, so we want to avoid getting hit with taxes every time we receive a distribution from these investments. Therefore, we would want to allocate our taxable bond exposure to this type of account because they are generally taxed as ordinary income. We want to shield that in tax-deferred accounts.
If we’re using actively-managed mutual funds for any of our exposure to equities markets, we would put those into tax-deferred accounts as well, because actively-managed mutual funds are going to have capital gains distributions, whether we sell these investments or not. And then we’d also include our exposure to assets like real estate. If we’re using real estate investment trusts for our real estate exposure, those generate a lot of income each year and they’re generally taxed at higher tax rates. It’s advantageous to put these in the type of account where we don’t pay tax every time these investments pay out.
Finally, in our tax-exempt accounts, we want to put our real high growth assets where we expect significant appreciation over long periods of time. So that’s where we’re going to allocate a lot of our exposure to U.S. small-cap companies. U.S. small-caps are an asset class that tends to be a little bit more volatile but, over long periods of time, tends to outperform some of the other asset classes in our portfolio. So these high-growth, highly-appreciated assets, we want to put in the accounts that we’re never going to pay tax on appreciation. Then, we’re going to try and get a lot of our exposure to international emerging markets, as well, for the same reasons as with U.S. small-caps. It’s a real long-term, high-growth asset. And by placing it in our tax-exempt account, we don’t ever have to pay tax on the appreciation.
The Benefit to You
By not just mirroring our asset allocation across all these different accounts, we’re leveraging some of the tax benefits of each of these accounts by matching them to the different features of these investments. And we’re just being a little bit smarter. We’re being a little bit more tax conscious. And what this is going to do is, over time, it’s going to subtly reduce some of the tax drag on your investment portfolio.
With an asset location strategy, we’re focusing not just on asset allocation, we’re looking at asset location. And by implementing it across all these different accounts strategically, we can add a little bit of value over long periods of time. Reducing the taxes that your portfolio generates each year might not seem like a lot, but when you compound that year after year, decade after decade, you can significantly add to the bottom line, keep more of what’s yours, pay less in taxes, and ultimately improve the performance of your overall investment strategy.
An Experienced Advisor Can Help
This is a nuanced strategy, and you may want a professional to guide you through it. At Creative Planning, we help our clients develop custom investment strategies to achieve their long-term goals. As a nationally recognized wealth management firm, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including CERTIFIED FINANCIAL PLANNER™ practitioners, certified public accountants, insurance specialists, attorneys and other professionals dedicated to helping you achieve your goals. We work together to help ensure all aspects of your financial life are well cared for.
If you’d like help developing your asset location strategy, or with any other financial matter, please schedule a meeting with us today.