Behind the Scenes of Your Portfolio: Taxes & Asset Location
This post is the second of our series looking behind the scenes of how we manage portfolios for our ongoing clients.
Behind the Scenes of Your Portfolio: Rebalancing
Often overlooked when thinking about your portfolio are the different ways that taxes are generated, based upon the type of accounts that own various asset classes. According to the “Vanguard Advisor’s Alpha” framework study from August 12, 2022, just by optimizing the location that different asset classes are held can add up to 0.60% annually in higher after-tax returns for investors! Let’s look at the way that asset location affects after-tax returns, starting with an understanding of the 3 main types of accounts:
Roth IRA/Roth 401(k)
401(k)/403(b)/Traditional IRA
Brokerage Accounts
Taxable Brokerage accounts (including living trusts), flow directly onto your annual income tax return. You have may heard us talking about Long-term Capital Gains, dividends and/or interest income and how it affects your income taxes. All of these are terms that apply to “taxable” accounts.
Tax-deferred accounts, including Traditional IRAs and 401ks, are accounts that generally have an upfront tax benefit and grow without ongoing taxes on dividends, interest and capital gains. However, the taxes in these accounts are only DEFERRED, in that taxes will be due when you choose to withdraw funds from these accounts to spend. Normally, these deferred taxes are at your ordinary income tax bracket in the year you spend the money.
Tax-exempt accounts include Roth IRAs, Roth 401ks and, if managed correctly, HSAs and 529 accounts. These accounts will grow TAX-FREE over your life. If managed correctly, tax-exempt Roth accounts can be one of the most valuable tools to build long-term after-tax wealth.
How We Manage Your Portfolio
Generally, we will buy municipal bonds and stocks with high capital gains (and low dividends) within taxable brokerage accounts. We’ll buy the most tax inefficient funds, such as commodities and real estate, within a tax-deferred account since we don’t have to worry about annual taxes on the income. Within tax-exempt accounts, we’ll focus on the highest upside investments, such as Emerging Markets stocks, to maximize the long-term growth rates without ever paying taxes again.
Unfortunately, while the concept is fairly straightforward, in practice, each client situation is complicated by a number of factors. This includes the amount in each type of account, the overall allocation between different asset classes, legacy securities with embedded taxable gains, sequence of investment returns for each asset class, the spread between taxable and tax-exempt bonds when we go to invest cash, and changing tax rates over time. As we manage each of our client portfolios on a total household view, rather than each individual account independently, we incorporate all these factors and more into choosing which accounts to place which trades.
The benefits do not show up on your pre-tax account statements, but we know result in tax savings, generating higher after-tax returns compared to a hands-off approach to asset location. Our job is to look at all the ways to help you grow your Net Worth and use your wealth for all the things that you find worthwhile.
