By Asiz Lalljee, Guest Writer
Taxes cannot be an afterthought in investment management. After asset allocation and fees, taxes most dramatically affect your investment returns. Every step of the investment process – from initial portfolio construction through ongoing portfolio management to realizing portfolio returns – implicates taxes. With tax season upon us, here's a basic primer on how taxes might interact with your portfolio.
Tax Deferral in Portfolio Construction
The taxable status of your investment account(s) is a central portfolio decision. You can use a taxable account, a tax-advantaged (deferred) account, or some combination of taxable or tax-deferred accounts as vehicles to alloc\ate and manage your investment portfolio. A separately managed account (the standard investment vehicle for families and small institutions) is typically taxable. IRAs, 401(k) s, investments held in certain types of trusts, and deferred annuities are common tax-deferred or tax-advantaged investment vehicles. Your choice of investment vehicle should reflect your marginal income tax bracket, level of investments, investment horizon, liquidity needs, and purpose of investment proceeds.
[Editor's Note: I disagree that “separately managed accounts are a “standard investment vehicle.” This term is often applied to a method for a financial advisor to gradually transfer money from your pocket to his via high fees. You certainly don't need a separately managed account to have a taxable account- you can just buy a no-load mutual fund directly at Vanguard. Also, be aware that this post has minimal discussion of tax-free or Roth accounts, another option that is generally preferred over fully taxable accounts, at least for retirement investing.]
The basic tax issue in portfolio construction is the timing of the tax incidence: tax is payable upon realized gain in taxable accounts, but is deferred in time or otherwise offset in tax-advantaged accounts. Relative to taxable accounts, tax-advantaged accounts often place significant limitations – as caps on investment value, annual contribution limits, limits on withdrawals, and/or narrowly defined uses for withdrawals – upon the account holder, which may limit their use for any particular investor or portfolio. Violations of these limitations may cause a tax-advantaged account to lose its tax-deferred (or other special) status and become taxable.
The Value of Tax Protection
Tax-deferral can be a valuable boost to your investment portfolio. Assuming your portfolio experiences a constant rate of growth, the present value difference between deferring and realizing gains as accrued can be over 10% in value after 10-15 years of deferral. The difference continues to grow with longer deferral horizons.
By investing in a tax-deferred account you are also showing an implicit preference for being taxed at future, rather than at current, tax rates; the preference is reversed if you choose to invest through a taxable account. So if you expect your marginal income tax rate in the future (say, during retirement) to be much lower than your present rate, tax-deferral may become especially attractive. But if tax rates rise substantially over the course of your investment horizon, the benefits of tax-deferral may be significantly eroded.
Given the limitations of use on tax-advantaged accounts, a basic principle of tax-efficient investing is to make tax-efficient investments through taxable accounts, and tax-inefficient investments through tax-advantaged accounts. A taxable account is typically suitable for investments in individual stocks and bonds held for over a year; stocks or funds that pay qualified dividends; municipal bonds (generally exempt from federal tax); or “tax-managed” stock or bond funds. On the other hand, tax-advantaged accounts should be generally reserved for securities held for less than a year; bonds or funds that generate high yields or non-qualified dividends; actively traded funds; and income from pass-through entities like LLCs or REITS.
[Editor's Note: Unfortunately, proper tax location is more complicated than just putting the least tax-efficient assets into the tax-protected accounts preferentially. You also have to account for the rate of return of the asset. Because of this, it often makes sense to put a tax-inefficent, but low-expected return asset such as bonds into a taxable account instead of a more tax-efficient, but higher expected return asset such as stocks. See this post for more details.]
Tax Implications of Portfolio Turnover
The taxable status of your investment account also matters when rebalancing your portfolio to maintain a target allocation across different asset and sub-asset classes. Rebalancing essentially entails selling ‘outperformers' and buying ‘underperformers,' incurring long or short term gains in the process. To offset this, you should rebalance as far as possible in a tax-deferred account, or ‘rebalance' by using new capital infusions to selectively buy ‘underperformers.' Similarly, actively-traded investments and strategies (generating short-term gains) should ideally be pursued through tax-advantaged accounts. [Or even better, not at all-ed.]
More broadly, the timing of investment gains dramatically affects your realized portfolio return. Investment gains are typically classified as Long-term Capital Gains (selling an asset owned for longer than 12 months for profit), Short-term Capital Gains (selling an asset owned for less than 12 months for profit), Ordinary Income (typically includes interest payments and unqualified dividends), and Qualified Dividends. Tax rates on investment gains vary based on your income tax bracket and marital status. At the top income bracket, Long-term Capital Gains and Qualified Dividends are currently taxed at 20%; Short-term Capital Gains and Ordinary Income at 39.6%. The implication here is clear: if you're generating a lot of interest income and short term capital gains in your portfolio (on which you're paying twice the tax you otherwise might pay!), it better make sense as part of your larger financial goals and investment approach.
[Editor's Note: Capital gains tax rates became much more complicated starting in 2014. Forbes has a good discussion of the changes. Basically, you may pay 0%, probably pay 15%, and may pay as much as 23.8%.]
Wealth and Income Effects of Changing Tax Rates
Finally, here's a little thought experiment on changing tax rates and your psychology as an investor. Changing tax rates are known to affect your savings and investment choices through the Income Effect and the Wealth Effect.
If tax rates rise, your disposable income is reduced, which might force you to reduce the amount you customarily save and invest. To maintain your original expected “payoff” at retirement, you now invest in riskier assets to offset the reduction in initial investment. You're effectively trying to do more with less – this is the Income Effect at work. On the other hand, rising taxes (and lower after-tax income) might make you feel ‘poorer' and less secure about your retirement. In other words, you become more risk-averse. To compensate, you invest more conservatively because you now have less ‘wealth to lose' – this is the Wealth Effect at work.
How these two opposing forces play out is a function of your wealth and income levels, your ‘marginal utilities’ of wealth and income, and their sensitivity to changing tax rates. Your investment adviser, who should have a through grasp of your risk tolerance and future cash flow needs, can help you anticipate and address the effects of changing tax rates on your portfolio.
The Bottom Line
Taxes should be a primary and ongoing focus of every investor. Consistent with your investment goals, liquidity needs, and risk profile, you should strive to maximize your after-tax returns. And your investment adviser's tax sophistication is central to your portfolio health.
[Founder's Note: I have a highly tax-efficient portfolio. It is almost completely contained in tax-protected (and asset-protected accounts,) and I take advantage of tax-loss harvesting and the donation of appreciated shares to charity.]
What do you (or your advisor) do to minimize the effect of taxes on your portfolio? Comment below!
[Editor's Note: Aziz Lalljee is co-founder and co-CEO of Finom, an online platform connecting investors with independent investment advisors. Although this is not a paid post, he is a paid advertiser on this site. He wishes to emphasize that no part of this post is intended, or should be construed, as constituting a specific recommendation, or as tax, legal, investment, or accounting advice. This discussion is general in nature and for informational purposes only; it is not a substitute for professional advice. This article was submitted and approved according to our Guest Post Policy.]
Sadly I have the opposite of WCI and about 90% of mine is in taxable accounts. I do enjoy the tax loss harvesting and donation of appreciated shares. The donation part alone saves me a lot in taxes.
high income earners are notorious for hating taxes and being convinced into tax avoidance schemes such as permanent life insurance. My old advisor tried convincing me to buy such a product. Luckily I found this web site and learned that not everything should be based on tax avoidance.
The way I see it:
Maximize your HSA
Maximize your tax differed accounts (401K, IRA, 403b)
Invest in a Backdoor Roth IRA
If you have extra money to invest then place it in a taxable account. If this amount is relatively high every year, consider starting a defined benefit plan.
In all those accounts invest in low cost index funds based on your desire and ability to take risk. If you are not sure or unwilling to manage an asset allocation, just by target date funds and don’t look back.
I think it’s that simple.
It certainly can be, assuming you’re coupling this strategy with an adequate savings rate.
Question on the placement of bonds: Should I not place bonds in accounts that I am going to pay most taxes on when withdrawing? (since bonds are going to grow slowest)
If I continue to work and save, just my RMDs are going to put me in atleast 20% bracket. (I know I can stop working early and convert to ROTH, but lets say I dont). If I have other income and my bracket increases to 25% (I love higher tax), wouldnt it be worthwhile to place my bonds in my 401K then? cause I am paying marginal tax rate on 401k while only capital gains on a taxable account?
When deciding an appropriate asset location, you have to take into consideration BOTH the tax-efficiency of the asset and the expected return of the asset. Suffice to say, in many situations bonds actually go in taxable. This topic discussed more here:
https://www.whitecoatinvestor.com/asset-location-bonds-go-in-taxable/
This article just smells like an attempt to scare people into permanent life insurance and variable annuities. Investing in a taxable is better than both the great majority of the time. In a taxable you can tax loss harvest, pay the better long term capital gains rates instead of income rates on gains, and you get a step up in basis at death. Annuities don’t have such benefits and cost more. Permanent insurance has tons of insurance costs with it which negate the step up basis it gets at death. One should be mindful of taxes but tax deferral is not the top priority.
all good thoughts
VAs can make sense if you find yourself putting tax inefficient investments in taxable accounts (limited room in IRAs etc) AND their costs are very low (Vanguard or Jefferson National)
Don’t forget to factor in 529s into location – if considered part of overall family portfolio (parents will be impacted by performance as they will make up any performance shortfall) then as 529s are tax free maybe locate fixed income having equities reside in parents taxable
SMAs can be low cost and tax efficient – Parametric (simulated index funds with loss harvesting) but high minimums -ideal if existing low basis stocks
locate highest expected returning investments in ROTH
I guess if your plan is for the parent to make up for 529 underperformance, then that’s reasonable. My plan is for the kid to make up for it.
The “highest expected return investment in Roth” is a bit of a fallacy. If you tax adjust your asset allocation, it doesn’t matter where you put your highest expected returning investments. Although I acknowledge few do this. But in reality, they’re boosting the overall portfolio expected return, but they’re doing so by taking more risk. They’re simply putting a higher proportion of the after-tax portfolio into high expected return assets.
most professional’s wealth will be concentrated in ret accounts
The taxes cannot be avoided, other than the state income tax by moving to a state that has no state income tax like FL, DEl
You can avoid a certain amount- the amount of your deductions and exemptions. Those dollars might have been saved with a 40% tax deduction and then come out tax free.
My first year being able to max IRA, 401ks for us both.
Next stop is taxable (don’t have access to HSA), correct?
I’ve considered a 529 heavily, just not sold on it. Now, I’m DCA $5k/mo split 60/40 in stocks/bonds (tax exempt) in a taxable account and hope to maximize my tax loss harvesting. Should I tax-loss harvest monthly or when I rebalance semi-annually?
Tax loss harvest any time you have a loss. If you have no other tax advantaged accounts available to you, then yes, a taxable account is the next stop.
Any advice for someone like myself?
I am fortunate enough to be a in fairly high earning specialty but am locked in an employee structure with terrible benefits.
I’m putting:
– 18K/year in a Roth 401k (I figured since I’m young and plan on working 30+ years, for now, may as well go Roth)
– 11K/year in a backdoor Roth IRA (spouse and myself)
– 84k/year in a taxable account at Vanguard
HSA is not an option unfortunately (and it’s limited space anyway) given the ineptitude of my HR department
Any other way to be more tax efficient? Thanks!
Im in nearly the same boat as you but my 401k is traditional not Roth.
This was discussed in the threads above, but I am putting all my bond allocation into muni bonds held in a taxable account. These are lower yield but tax free. I like the idea that the only thing I will pay taxes on annually is the VTSAX (a very tax efficient fund) in my taxable acct.
I get what WCI is saying about roth IRAs, but I am putting more aggressive/higher yielding assets in mine. This year its REITs. Next year I may try P2P lending.
I agree that taxes arent the be all and end all, but if you can avoid them and avoid fees (and advisers) you will be richer!
Interesting, all the bonds in my taxable account are also intermediate term muni bonds. I like your idea of keeping all my bonds in the taxable account and trying to be more aggressive in the tax-protected Roth space. Thanks!
If you do some moonlighting you could do an individual 401(k).
munis are great in taxable accts
for 40 yrs I bought long term investment grade or better individual bonds
nothing like tax free income for life, even with today’s rates
Agree with tax-exempt bonds/funds in taxable accounts, despite current low rate environment.
For simplicity, over the years I have laddered tax-exempt Vanguard municipal bond funds as the fixed income allocation of my taxable portfolio. Have approximately equal amounts in limited, intermediate, long term and high yield tax-exempt funds.
Plan on using monthly income off these funds and dividends off indexed broad market equity funds in taxable portfolio to live on when I retire this year.
I understand that interest rates will likely increase sometime in the near future and share value will decrease, I will be indifferent to decrease in share value as I do not plan on cashing in shares, just relying on their income.
Don’t forget the effect of inflation on bond values as well. But since you’re just spending the distributions of your stock funds, no big deal as you should get inflation protection there. Sounds like you’re going to have a very low withdrawal rate, which is almost surely sustainable in the long term.
Yes, withdraw rate will be very low by just spending dividends and capital gains from mutual funds. I know in years when large expenditure occurs, such as new vehicle, will likely need to liquidate some shares. Working off of total portfolio over 8 million.
First world problems, the best kind to have!
WCI thank you for building such an awesome resource with this website
I’m sure this is addressed in another post, but since it’s certainly related to the whole tax efficiency conversation I wanted to throw out my situation to get some advice, as I’m sure there are other readers facing similar decisions. Here goes:
-high current income sub specialty (>800,000/yr) but high chance of less reimbursement in 5-10 years with Medicare and insurance shifting payments away from procedures
-partner in 2 physician private practice (S corp) with around $350k left in buy-in loan, which is at prime + 1% (currently 4.25%) for five year term
-owner of 50% of the practice real estate (in separate LLC)
-maxing backdoor Roth (and spousal), HSA, 401k + profit sharing
-mortgage locked at 4.1% with ~$900k left on 30yr
-small taxable account with Vanguard
-no kids yet so no need yet for 529 plans
My dilemma is what to do with any extra after tax income. At our current spending levels I’ve had about $50-75k per quarter extra to invest after all expenses and taxes. Do I pay down the buy-in loan first (since rate likely to rise with fed increases), then move on to mortgage, or do I invest a certain amount along the way into taxable account. If so I would likely split 50/50 between a broad stock index and intermediate term muni fund.
I realize this is a fortunate situation to be in, but with the future of medicine reimbursement being so murky, I feel the need to maximize every penny now! I just want to make the right moves so that if in fact my income takes a 40% hit by ten years I’d still be sitting pretty.
My thoughts are that since I’m probably already saving enough for retirement in those tax deferred accounts, maybe paying down debt should take priority, especially since at my income even the mortgage deduction gets phased out. I’d certainly start with paying extra principal on the buy-in loan (since that’s variable and already at a higher rate) rather than the mortgage.
Thoughts??
I agree that paying down debt ought to be given fairly high priority. I know you have a high income, but you also owe over a million bucks. I certainly see no reason to buy a muni bond fund paying less than 2% when you have a 4%+ (admittedly less after-tax) guaranteed investment. If you want to throw some of it into taxable stock funds, I think that’s fine, but I’d be throwing the vast majority at the debt. $1.25M * 4% = ~ $50K a year in interest alone. It will be nice not to have that if you decide to cut back or if your income gets whacked.
I hear you on the debt being important to make a dent in along the way. I guess what I’m having trouble with is the fact that at my age (mid 30’s), I’d have a lot of time for a taxable account to compound along with the retirement accounts to provide a significant source of extra income for my retirement years and even to consider an early retirement. This is tempting in the sense of achieving a net worth that I’d feel comfortable with prior to deciding to retire…
In contrast, any $$ I put into paying off my buy-in loan early would in a sense be lost investment income. I’m still assuming buying into the practice was a good idea (and I know you’re a big component of a physician owning his own business), but there are no guarantees there, especially with valuations likely to change, that I’ll get back out what I put in when I go to sell And sure, hiring other docs/midlevels to join the practice and generate revenue for me would result in more income…a good portion of which I’d like to invest but then would have missed a lot of my earlier valuable investing years!! See the dilemma? Circular.
Just split it then. Pay half to your debt, invest the other half. That is what I did in a similar situation…
What specialty pays more than 800K?
Aesthetic + surgical dermatology with separately running aesthetic center that is part of the practice
From Glenn Frank via email:
Regarding highest expected returning investment in ROTH
– good point on fallacy but it should not be a fallacy IF only holding investments that would be somewhere in the portfolio anyway (agree do not want to take on unnecessary/unintended risk) AND that the portfolio is continually rebalanced to an appropriate tax/risk/return needed adjusted allocation. In essence I would rather have by big hitter bat 4th assuming they were going to be somewhere in the line up anyway!
Regarding muni bond in taxable or corp/gov bond in retirement:
I think math supports deciding where to place highest returning/big compounding equities first and then the less impactful bonds. So if equities high turnover hold in retirement and if high enough bracket hold munis in taxable. If equities tax efficient (low turnover,low cap gain list, qualified div, loss harvesting potential) hold in taxable and then place comparable credit/interest rate risk bonds in retirement.
regarding munis or debt:
agree w White Coat if after tax cost of debt (which is a definite) is greater than after tax return on muni (which is a risk) in general should be an easy decision (if liquidity is an issue an you want to have munis to sell if needed -may be better to have a line of credit on home and/or margin a taxable account on portfolio for a rainy day which hopefully never comes )