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With campaign season finally over, taxes are going to dominate the debate in Washington in the months ahead – however things shake out at the polls today. It’s going to be confusing; it’s going to be uncertain. But many of the most critical questions advisors will ask can be answered with an analytical approach to deciding where to “house” assets – in taxable or tax-sheltered accounts.
Here are just a few such questions: What if dividends lose their “qualified” status, which allows them to be taxed at 15%? How should advisors prepare for likely increases in capital gains rates? What assets are best to hold in a Roth or a 529 plan? And what about a variable annuity – will purchasing one help?
When it comes to those questions and others, advisors can systematically analyze the tax implications of high-net worth portfolios and generate actionable advice as a result. In what may be a low-return environment for several years, minimizing taxes is a great way to endear ourselves to clients in an area far too complicated for them to do themselves. Be a hero and generate what I like to call “tax alpha”!
Crafting the process
Determining the optimal location (in the tax status sense) of an investment should be a distinct step in your investment process. Too many advisors forget or overlook this important consideration, which is perhaps unsurprising, given how complex our ever-changing tax code has become.
In years past, many advisors used mostly straightforward stocks and bonds, but those days are long gone. Accompanying the incredible proliferation of investment vehicles has been diversification available across an ever-broadening set of global markets. And, facing a highly volatile and uncertain market, more and more advisors are making short-term tactical trades, which can be expensive tax-wise without proper planning. All of these modern realities are making tax considerations more and more complicated to unravel.
It can be hard to know where to begin.
One way to start is to make sure you’re asking the right questions when you reach the location phase of your process. Here are several that all advisors should be asking:
- Which asset classes do clients currently hold, and what embedded capital gains are in each account?
- What new asset classes would clients ideally embrace, once their financial planning and risk tolerance has been reassessed?
- Which managers are best to capture the targeted asset classes? What should the mix of actively managed funds, separately managed accounts, or passive funds be?
- How do income and estate tax considerations affect the choice between taxable and tax-deferred accounts?
- What are the tax implications of portfolio rebalancing?
Thinking holistically
With those considerations in mind, advisors should begin by thinking holistically. Most clients want to maximize family wealth, so start by considering a client’s accounts, including both those that are currently taxed and those that are sheltered, all together at once. Taxable accounts generally include brokerage accounts, trusts and children’s custodial accounts. Sheltered accounts include annuities, the cash value of insurance policies, 529, 401(k), IRA and Roth IRA plans.
Next, put everything on a spreadsheet, organized by asset class – I call this the family investment matrix. (This is a useful exercise in its own right – I find many clients have an epiphany when they see their asset allocation in its totality for the first time.)
When it comes to the location issue, the key is to understand thoroughly the possible taxes each investment may incur. How is each client account taxed, both as income in the short term and, eventually, for estate-tax purposes? What is the character and timing of taxable gain recognition for each investment manager? Will 1099s and K1s include ordinary income, short- or long-term capital gains, qualified or non-qualified dividends, or foreign tax credits?
Once you’ve made these assessments for each investment, go through an ordering process to rank all of the funds used by tax efficiency. For example, large-cap US stocks in an index fund or ETF are highly tax efficient, with few capital gains and dividends taxed at just 15%, at least for now. At the other end of the spectrum are high-turnover REIT mutual funds, with short-term capital gains and rent yields taxed at the highest marginal rates, and high-yield bonds.
Accordingly, it makes sense to hold an S&P 500 ETF in a taxable account, while an active REIT mutual fund is more appropriate for an IRA.
The most important location decision, however, is where to place equities. Because of long-term compounding on equities, which should offer higher returns than other asset classes, their tax treatment can have dramatic effects on overall performance. Put tax-efficient equities in taxable accounts and inefficient equities in a tax-free retirement vehicle – only then should you determine locations for fixed income. For example, if equities have high turnover (and are likely to realize short-term gains) they belong in tax-deferred accounts, and bonds belong in taxable accounts (if the client is in a high enough tax bracket, buy munis).
Putting assets that are subject to long-term capital gains treatment into sheltered accounts is like turning gold into lead.
As tax laws change, the ordering process should also change. For example, if qualified dividends lose their 15% rate in 2013, as currently scheduled, the tax efficiency ranking of certain managers will drop accordingly.
Specific steps that make tax sense
This may all sound straightforward, but of course the details are where it can get complicated. Within this general context, here a number of examples of how the asset location decision enters into play:
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Strategically locate assets in 529 plans. Handling 529 plans often depends on whether they are considered part of the family portfolio, or whether they represent a separate pot of money set aside strictly for education. The answer to this question lies in the answer to another question: Who will make up the shortfall if the 529 fails to meet the cost of education? If it’s the parents, then the plan’s performance will affect them, and therefore the 529 should be treated as part of the family portfolio. In this case, a 529 is a marvelous place to put fixed income, given its tax-free status. Family growth assets can be located somewhere else under parental control. (An added benefit of fixed income in a 529 is that it is predictable for budgeting purposes.) Growth assets should then be outside of a 529 plan.
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Buy low-cost annuities to house tax-inefficient asset classes when there is no room in retirement accounts. It’s great to put tax-inefficient assets into retirement accounts, but the capacity of these accounts may be limited. For example, say the asset mix includes REITs and/or high-yield bonds, but the retirement accounts are already full or, as is sometimes the case with some 401(k) plans, do not offer these investment options. If such assets go into taxable accounts, too much will be lost to taxes. As an alternative, an investor can use low-cost variable annuities, such as Jefferson National and Vanguard annuities, to house these tax-inefficient asset classes.
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Certain assets almost always belong in taxable accounts. Buy-and-hold equities, most index funds, and most ETFs (except for some that are heavily taxed every year) rarely make sense for tax deferral.
Unlike mutual funds, a separately-managed account (SMA) can harvest losses during the year, which can work very well in a taxable account. SMAs (such as Parametric’s TEMC tax-efficient market-capture platform) that track an index with ongoing tax-loss harvesting capture the performance of an index such as large-cap US equity, giving clients S&P 500 returns, while harvesting losses during the year to offset other gains in the portfolio. These give an investor the benefits of an index fund, with tax efficiency as an added bonus.
Certain limited partnerships, such as timber and private equity, usually offer long-term capital gains and should be in taxable accounts. The same applies to most ETNs, which, under current tax law, have tax-favored status.
The active-passive debate also enters into play. Most analysis of active-versus-passive strategies is on a pre-tax basis. On a post-tax basis, passive has a big edge. If you like active managers, all things being equal, it is better to keep them in tax-deferred or tax-free environments. Otherwise, you can get married to a manager you love, and then the manager leaves and you must pay capital gains taxes to move your money. In a retirement account, you don’t have that problem.
The pendulum can swing on this issue, however. For example if a client has significant capital-loss carryovers (thank you, 2008), then SMAs with short- and long-term gains and active funds with long-term capital gains distributions (not short-term distributions, which come out on 1099 as ordinary income) are effectively tax-free until the carryovers are used up.
Capital-loss carryovers are a “get out of tax jail free card” that you have to decide when to play, though, since heirs cannot inherit those losses. Accordingly, in these situations I often sell munis and buy equities in taxable accounts. To keep risk levels intact, I sell equities and buy bonds in retirement accounts. The stocks can be sold later without tax, up to the extent of loss carryovers. Otherwise the equity appreciation would have ultimately come out as ordinary income from the retirement account.
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Certain assets almost always belong in accounts that are not currently taxed. High-yield bonds, REITs and high-turnover managers are all prime candidates for tax-free status. Hedge funds can be very tax-inefficient, and it can be vexing to wait for K1s that don’t come until October. When permissible, hold them in a retirement account.
What’s more, many new alternative investments involve short-term trading strategies that hinder tax efficiency. Advisors who employ tactical shifts also trigger current taxation. In both cases, by holding these assets in retirement accounts, the investment alpha generated will not be subject to a huge tax drag.
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There are quantifiable benefits to paying capital gains taxes on concentrated positions, in order to reduce portfolio volatility. With concentrated positions, advisors want diversification, but getting clients to write a big check to IRS is tough. As an advisor, you know you can’t promise a higher return on a diversified portfolio, but you can promise reduced volatility – and reducing volatility by paying taxes today makes a lot of financial sense. The size and frequency of potential losses is far greater with single stocks than for a diversified portfolio, and big losses kill the effects of compounding. (Plus, clients with diversified portfolios can actually sleep at night.) A sale is particularly compelling today, before the 15% capital rates sunsets on January 1.
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Consider the estate tax. Estate issues are very specific to each client’s individual circumstances, so general guidelines are dangerous. Advisors must look to the ultimate disposition of the account. If taxable accounts are likely to pass to the next generation (and step-up in basis laws are in effect), then you can put buy-and-hold equities in these accounts and any appreciation will never incur a capital gains tax. There is no step-up for retirement accounts.
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The philanthropic side is important to consider. When charitable giving comes into play, house buy-and-hold equities in taxable accounts; doing so allows for a full deduction, while avoiding tax on unrealized gains. If high-turnover assets are housed in taxable accounts, on the other hand, you pay taxes continually – accordingly, you would not avoid very much capital gains taxation by gifting them.
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Time matters. The younger you are, the more sense it makes to house the highest-expected-return investments in tax-deferred accounts. Decades of growth with zero tax interference can fuel a tremendous accumulation, even after taxes are paid at the end. As Roth IRAs are often the last account to draw down, housing high-returning/tax-inefficient investments there will have an even greater benefit, as returns come out completely tax-free.
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Proactively pay long-term capital gains taxes in 2012. As long-term gains rates are scheduled to go up from 15% to 20% in 2013 (although Congress may yet delay this change for another year), realizing gains this year that would have otherwise been incurred over the next few years makes sense. If higher rates become permanent, then you’ll need to revise ordering rules for housing assets. A key goal at all times is to not end up with a net short-term gain on a client’s Schedule D; these gains are taxed at the client’s highest marginal rate, which could surpass 40% federally (to say nothing of state taxes) in 2013.
None of these rules work universally, it’s important to realize, and blindly following them is dangerous. But much of the commentary on asset location in the past has been too simplistic, failing to recognize the diversity of assets typically held in high-net worth portfolios, and these guidelines are a good start for a fresh approach. My goal is to sensitize advisors to these issues and to offer a logical framework to employ at this critical step in the investment process.
Appendix: An example showing how much investment location matters
About the client: A couple in their early 40s, trying to maximize after-tax accumulations over next 20 years.
- They face a federal tax rate of 33%, a state tax rate of 5%. Their federal capital gains rate is 15%, with state at 5%.
- They have $400,000 invested in taxable accounts, $400,000 in IRAs, and $200,000 in Roth IRAs. All accounts will ultimately be used for retirement.
- All accounts have a traditional 60/40 allocation (60% equities and 40% bonds).
- Historical returns of 5% are assumed for bonds and 10% for equities, which are in turn assumed to be 2/3 buy-and-hold ETFs and 1/3 actively managed funds.
Your goal:
- Improve the portfolio’s tax efficiency by moving investments to proper accounts, without changing the established asset allocation.
What you should do:
- Move bonds (high-yield, with no tax break) entirely in to the IRA.
- Move active equities (relatively tax-inefficient, yet higher-returning than bonds) entirely into the Roth.
- Move equity ETFs (lower-yielding than bonds with currently tax-advantaged dividends) into the taxable account.
The result:
- The couple’s overall asset allocation is still 60/40, in line with their risk tolerance and goals.
- The tax efficiency of their total portfolio has improved dramatically. As a result of these moves, the total accumulation in year 20, after all taxes are paid, is over 8% greater: $4,156,000 versus $3,812,000, saving $344,000. This is essentially “free money,” since the improvement happened with identical investments and identical risk risk; you simply located investments optimally to take advantage of basic tax law.
These savings are all from income taxes. If, for example, the taxable account passed to the next generation before positions were sold and the heirs received a step-up in basis, the tax savings would increase by $192,000, making the difference in the portfolio’s total accumulation close to 12%.
Glenn Frank is the director of investment tax strategy for Lexington Wealth Management in Lexington, MA, and he was the founding director of the Master of Personal Financial Planning program at Bentley University in Waltham, MA. He is a member of the program’s advisory board and teaches two portfolio construction courses within the program – Portfolio Management and Investment Vehicles. He is also the patent holder on “OptiTax” – a software tool that optimizes the location of investments between taxable and tax-deferred accounts.
Read more articles by Glenn Frank
