Tax Efficient Investing
The name of the game in investing is growing wealth. One of the biggest drags on that growth are the taxes you pay on the income, interest, and gains that your investments produce. If your investments earn you $100,000 in a given year, that’s great. But if you owe 20%, 30% or 40% of that growth in taxes—well, that’s a lot less great.
Perhaps it would be more accurate to say that the name of the game in investing is not only about growing wealth, but about growing wealth after taxes.
Thankfully, current technology allows investors to be as efficient as we’ve ever been in meeting that objective. But gaining that tax efficiency requires thoughtful planning, and that’s what this post is going to focus on.
What is Tax Efficient Investing?
Another name for tax efficient investing is Asset Location, and that name aptly describes what the strategy does.
First, assets. Inside your portfolio of investments you hold different assets (stocks, bonds, alternatives, etc.). The gains produced by those various assets are treated differently in the tax code. On one hand, consider bonds. Bonds produce interest, which are taxed at ordinary income tax rates, so we’d say that bonds are tax inefficient. On the other hand, growth stocks which issue no dividends aren’t taxed at all until you sell them. At that point, if you’ve held them for greater than one year, any gains are taxed at capital gains tax rates, so we’d say that growth stocks are tax-efficient.
Second, location. Location refers to the type of account in which you hold the investments. There are basically two camps—taxable accounts and tax-advantaged accounts. In taxable accounts, for any gains that you accumulate throughout the year (interest, dividends, realized capital gains), you owe taxes on those gains that year. In tax-advantaged accounts, for any gains that you accumulate throughout the year, the taxes are either deferred or avoided entirely. For tax-deferred accounts (401k, Traditional IRA, etc.), you will eventually pay taxes when you distribute money from the account. For tax-free accounts (Roth IRA, 529 plan, H.S.A.), you will never have to pay taxes on the growth.
In general, you want to locate tax-efficient assets inside of taxable accounts, since those assets don’t produce much tax anyway, and you want to locate tax-inefficient assets inside of tax-advantaged accounts so you can defer or avoid the taxes owed.
Asset Location at PWA
A few years ago, we transitioned client portfolios to a tax-efficient approach, with strategic asset location. While this approach is good for any investor, it is especially beneficial for our investment approach at PWA primarily for one reason: the Vega Strategy.
Vega remains the asset with the highest expected rate of return, however, it’s also our most tax-inefficient asset. Nearly all the gains produced by Vega are short-term capital gains, which are taxed at ordinary income rates. That makes Vega a perfect candidate for an asset that should be located in a tax-advantaged account, where those gains can be deferred or even avoided entirely.
A Case Study in Asset Location: The Year 2020
A year such as the one we’ve had in 2020 is the perfect example for why asset location matters. Through November, the Vega strategy is up around 46% on the year. That return is great. With tax-efficient portfolios, when the taxes on most of those gains are avoided, that’s even better.
Below is an example to illustrate.
Portfolio A and Portfolio B are nearly identical. Both have a starting balance of $1MM, both earn a total before-tax return of nearly 23%, resulting in roughly $230,000 of portfolio growth. And both of those are great outcomes toward the goal of growing wealth. But they aren’t equal in growing wealth after taxes.
Portfolio A generated over $18,000 in taxes owed this year, while Portfolio B generated only a little more than $200.
The only difference between the two is asset location. We hold tax-inefficient assets (namely, Vega) in tax-advantaged accounts, leaving taxable accounts to hold the already tax-efficient assets (namely, Stocks).
Our Take
Not every investor’s situation can fully maximize the benefits of asset location. In fact, your portfolio must have different types of accounts—both taxable and tax-advantaged—to truly see the benefits. And the tax savings won’t always be as large as they’ve been this year.
But for those portfolios that can benefit, they should utilize asset location. We can take advantage of the technology that facilitates this, all while maintaining the target asset allocation and controlling risk exposure. A little bit of planning can make a great deal of difference to your after-tax wealth.