Asset Location and Tax-Efficient Investing

How do you allocate assets over your multiple accounts?

First, you want to pay less in taxes. Tax-Efficient Investing becomes critical as the size of your brokerage account increases.

How can you optimize asset location? Which funds go into which accounts? How does tax-efficient fund placement improve returns? And how does it affect risk?

First, we need to understand how taxation affects tax-efficient fund placement and the asset allocation of multiple account types. Then, we must understand asset location and where funds go.

Multiple Account Types and Tax-Efficient Fund Placement

Let’s look at the different account types most of us have available for investing. Our investments are held in different “buckets” or “wrappers.”

Taxable (Brokerage Account)

There are the taxable buckets—our brokerage and savings accounts. Every year you pay ordinary taxes on interest and short term capital gains, and you pay capital gains taxes on dividends and long term capital gains. This is called tax drag.

Tax-Free (Roth)

Next, the tax-free bucket, usually called Roth. You have already paid taxes on these accounts and can utilize them in the future without tax implications.

In addition, there are additional sources of tax-free money. For example, you have the basis on your brokerage investments (where you have already paid tax) and loans (on homes, life insurance, brokerage accounts, etc.), where you also get tax-free income. Finally, don’t forget your HSA.

Pre-Tax (Retirement Accounts)

Finally, there is pre-tax money. These accounts are where the rubber meets the road. IRAs, 401k, 403b, 457 plans are all taxes waiting to happen, ticking time bombs. You don’t own these accounts outright! You own a percentage of them, and the government owns the rest. The difficulty with these accounts is that future taxes are unknown, so you don’t know what these are worth!

For instance, if you have no other income, you can take money out of these accounts and fill up your standard deduction tax-free. So you put the money in and get a tax deduction—you take it out, and it is tax-free! Brilliant!

But if you have a pension and social security filling up your standard deduction and even your 10 and 12/15% tax brackets, you might pay more in taxes on these accounts in the future than you got in deductions in the past. Not cool, Uncle Sam!

Also, it’s not cool—Required Minimum Distributions. Sam wants his money back, forcing you to withdraw income from these pre-tax accounts once you turn 73 or 75.

Tax-Sheltered

Another tidbit to be tax-efficient: some of your accounts grow tax-deferred. These are also called tax-sheltered. Pre-tax accounts and, of course, tax-free accounts grow tax-sheltered. As a result, there is no yearly tax drag, which improves long-term returns.

Insurance products like annuities and cash value life insurance also grow tax-deferred.

Finally, you can shelter W-2 income using business deductions, real estate, or farm or ranch income.

Next, let’s look at examples of optimized and poor asset locations. What does a portfolio optimized for tax efficiency look like?

What Does Optimized Asset Location Look Like?

Folks are often tempted to locate their assets equally. A poorly optimized portfolio looks something like this:

Above is an example of a 60/40 portfolio. Each account type—the brokerage (taxable), pre-tax (tax-deferred), and tax-free (tax-exempt)—is 60/40. The total net worth is $2.5M.

Why isn’t this tax-efficient?

In the taxable account, you pay ordinary taxes on the bond income. Since we are talking about a brokerage account, you invest above and beyond the basic pre-tax retirement plans. You have a high income, and bonds belong in your pre-tax retirement accounts to save in tax drag.

Funds with lower expected returns are in the tax-free bucket. Once you have paid taxes and have a long time frame, investing for high expected returns makes sense. There are no bonds in Roth! We need to optimize asset location in our multiple accounts.

A Tax-Efficient Fund Placement Example

Above, now you have all your international equities in your brokerage account. You can take advantage of the tax break from the foreign tax credit.

Also, all your bonds are in a tax-sheltered account with no tax drag. Finally, Roth has all equities with higher expected returns.

Note: To get to 40% fixed income, the tax-deferred account is now 100% in bonds! This lowers the future expected returns and, thus, future taxes. Required Minimum Distributions will be lower, and you can pay less in taxes in the future.

You expect more money in the Roth account BECAUSE you are taking more risk. Equities are riskier than bonds, but the money will be yours rather than shared in the future. So, you take all the risks and get all the rewards.

Let’s look at another way to visualize an optimized asset location.

Another Way to Visualize Optimal Asset Location 

See above for another example of optimal asset location. Here, the entire portfolio is in one pie graph. This is an excellent example of tax-efficient fund placement!

In this portfolio, 50% of the assets are pre-tax, 40% are in a brokerage account, and 10% are Roth.

The overall asset allocation is 60% equities (blue) and 40% fixed income. Note that blue (equities) has several different types of index fund ETFs, while the 40% fixed income is broken out into several additional funds.

The brokerage account represents 40% of the portfolio in the top right corner. It is tax-optimized in international equity ETFs. The remaining is allocated to US equity ETFs. Remember, you want to use tax-efficient ETFs in the brokerage account rather than mutual funds, which may pay out yearly income (via forced distributions) you don’t want.

In the Roth, 10% of the portfolio is entirely in equities. Consider a small-cap value fund or other “tilt” with higher expected returns. Whether there are short-term capital gains, ordinary income, or a significant turnover in this tax-sheltered account doesn’t matter.

Finally, the pre-tax portion is 50% of the portfolio total. The last 10% of equities (blue) can be in tax-inefficient equity funds such as REITs, managed futures, or GLDM. This is also where your fixed income goes. Say 20% total bonds, 12% short-term bonds, 5% TIPS, and 3% cash. Or whatever.

With that, how do you set up your portfolio for tax perfection?

Tax-Perfection and Considerations for Retirement 

Let’s get set up for tax perfection! When making money, put it away tax-efficiently in your three types of accounts. The goal is good tax diversification with investments in all three account types.

Then, have a long Tax Planning Window.  Here, you convert the pre-tax to Roth while having no other sources of income and thus access to the standard deduction and lower tax brackets.  This strategy utilizes tax arbitrage, where you save taxes when deferring income but then convert to Roth when you access the lower tax brackets. Live off the basis in the brokerage account to minimize capital gains.

Now, you have control over your income in retirement! Take exactly what you need from the pre-tax accounts to fill up the standard deduction and the lower tax brackets. Since you minimized the size of the pre-tax accounts, Required Minimum Distributions don’t force out extra money and thus additional taxes. If extra money is needed (you don’t want to hit cliff penalties like IRMAA), steal money from the Roths.

Next, let’s quickly look at some additional tax considerations in retirement. These are breakpoints, cliffs, or other retirement tax planning goals.

Tax Bracket Management

Here, know where your standard deduction and lower tax brackets fall so you can harvest your pre-tax money annually and optimize lower taxes. Required Minimum Distributions mess with your plans, so doing partial Roth conversions or living off the pre-tax accounts before 75 may make a lot of sense in a tax-efficient retirement income plan.

Surcharges

IRMAA can be a pain in the rear. It is a cliff surcharge, so it must be managed carefully. For most well-to-do retirees, this will be a focus and goal for income management in retirement.

Capital Gains Zero Percent Tax Bracket

Below a certain income, you can harvest capital gains tax-free!

NIIT

You may also want to avoid NIIT if you are harvesting capital gains or have an income above 200k/250k.

 

Yield-Split Method of Tax-Efficient Fund Placement

Kitces codifies using dividend (and other) yield of equity funds to go even one step further down the path of tax-efficient fund placement.

You can put your value stocks in your brokerage account because they have less tax drag and put your growth stocks in a tax-sheltered account due to the slightly higher yield—same thing with bonds. Tax-efficient treasuries can go into the brokerage account, and higher-yielding corporates go in tax-sheltered.

 

Above is a top-drawer graph from the blog on the yield-split asset location strategy with specific funds from iShares and Vanguard. Have at it if you want to go from a three-fund portfolio to a yield-split one. If you do it well over time, your portfolio may be 6% larger (15 basis points a year in savings due to tax drag).

Conclusion- Tax-Efficient Fund Placement and Asset Location Optimization

Remember, the government owns part of your pre-tax accounts.

And tax drag: capital gains and bonds income drag returns in the brokerage account.

You can optimize your asset location if you don’t lose the big picture—risk. If you can tolerate the risk of having all equities in your taxable accounts—and don’t need the liquidity—you will pay less in taxes. If you can tolerate the risk in your Roth accounts, you will be rewarded with higher expected growth over the decades. And, if you leverage debt, you can have greater returns due to more risk.

You are usually better off placing funds with higher expected returns in Roth accounts. If you take a risk in your pre-tax accounts, the government shares the risk and gets taxes on the return.

With asset location optimization—tax-efficient fund placement—you need to consider the asset class’s future expected returns and tax efficiency.

Sounds like a lot? It is! Retirement income planning—tax-optimized retirement income planning—is a lot to think about.

But you need to start somewhere. If you want a bit easier, read: Visualize the 3-Fund Portfolio Across Multiple Account Types.