Is Your Portfolio "Tax Optimized?"
When it comes to structuring a tax-efficient investment portfolio, we believe it is important to consider “asset location.” That is—which types of investments should be held in which type of investment account? Conventional wisdom would reason as follows:
Tax-efficient investments should be held primarily in personal brokerage accounts. This could include municipal bond funds, tax-efficient index funds and even individual stocks.
Tax-inefficient or “income generating” investments should be held in tax-favored accounts like IRAs and 401k plans. This would include most fixed income investments (bonds, preferred stocks, TIPS), as well as certain types of stock investments including REITS, dividend payer stocks and some actively managed stock mutual funds.
This “conventional wisdom” works well for those who are retired and have the flexibility to withdraw funds, without penalty, from any of their accounts. However, positioning income generating (mostly conservative) investments in IRAs and tax-efficient (growth-oriented) investments in personal brokerage accounts, may not always be a good idea.
This is especially the case for those investors who are in the accumulation phase of their investment life cycle. You might recall that we consider “accumulators” as those investors who are at least 10 years away from retirement.
What is different about accumulators?
The primary factor that influences asset location decisions for accumulators is the fact that distributions (prior to the age of 59 1/2) from IRAs and 401k plans could be subject to income tax and a hefty 10% penalty on the distribution. As such, when forced to take a distribution from their accounts (as a result of an extended unemployment or major unexpected expense), the most tax-efficient distribution order would likely be as follows:
Cash held in an emergency fund (no tax penalty)
Proceeds from a personal investment account (no penalty and little or no tax impact)
Original contributions in a Roth IRAs (there is no tax or penalty when withdrawing original contributions)
Distribution from IRA or 401k plan (both are subjected to penalties and taxes)
Investment Strategy for Accumulators
Given the fact that for most accumulators, their personal brokerage account is considered “on deck” money for distribution purposes, we generally suggest an investment strategy that is both tax-efficient and more conservatively positioned than their retirement accounts. By being more conservative in a personal brokerage account, the hope is that there is some protection from selling equity investments at an inopportune time (after a stock market decline) in order to pay for an unexpected expense.
Portfolio Customization is Critical
Determining an appropriate investment strategy is a process that should be customized to reflect both the risk tolerance (emotional ability to withstand risk) and the risk capacity (the financial ability to withstand risk) of each investor. We believe that working with an investment advisor who has the experience and the ability to consider, and minimize, the detrimental impact of taxes is a critically important component when building an enduring portfolio.