Earlier this month, we published an article explaining why investors would be well served to organize their portfolios like their kitchens. This process, one that the finance industry calls ‘asset location’, is simply intended to make the most of the existing tax code. The IRS sets the rules with different tax treatment for different account types and our objective as wealth managers is to most efficiently locate assets in these different account types to minimize long-term taxes.
Investors who pay no taxes don’t have as much to gain from asset location (only the benefit of reduced transaction costs). But if you are among the segment of the population that pays Uncle Sam every year, this is one of the most powerful and underutilized tax savings opportunities. How do we know it’s underutilized? When we look at statements of a new financial planning prospect for the first time, we see firsthand the clear and expensive mistakes that the majority of investors or their advisors are making by not taking the time to apply effective asset location.
If your goal is to save big on taxes, then you ought to start by focusing not on the small deductions but on the big 4, 5, and 6-digit tax saving opportunities that you’re not already utilizing. We have already explained the math on how intelligent asset location can save you dramatically on taxes. Here we explain some of the most common mistakes that investors make and how they can be avoided.
Mistake: You own tax-exempt municipal bonds in a brokerage account at the same time that you own stocks in a traditional 401(k) or IRA.
Investors own municipal bonds because they want the safety of fixed income without the harm of taxable income. If you have enough room in tax deferred accounts like IRAs and 401(k)’s, you should simply use those accounts to own taxable fixed income where the yields are inherently higher than municipal bonds, the taxable income is not an issue, and the desired safety of fixed income is retained. Regardless of how high your tax rate is, there is rarely a compelling reason to own tax-exempt municipal bonds in a taxable brokerage account if you have a large percentage of your liquid wealth in IRAs or 401(k)’s. Instead, use the IRA or 401(k) to purchase taxable bonds with higher yields.
Mistake: You own high quality bonds or bond funds in a Roth IRA or Roth 401(k).
The tax-free nature of a Roth account is best exploited by growth. This is math. When you have tax free growth, you get limited benefit from the “tax free” feature if there is no or limited growth. As a result, contributing to a Roth IRA and then funding it with low expected return investments (i.e. high quality taxable bonds) is like a basketball team paying an enormous salary to a healthy Stephen Curry but then leaving him on the bench for the entirety of three straight seasons. Tax free Roth accounts are a precious commodity. If you own any bonds or bond funds in a Roth account, you’re likely wasting that precious commodity.
Mistake: You own a stock or fund you expect to grow rapidly in a tax deferred IRA or 401(k) account.
This may be one of the most common mistakes we encounter. Someone in a high tax bracket gets a hot stock tip and buys the stock in a traditional IRA. What needs to be understood is that a traditional IRA or 401(k) is a partnership between you and the IRS where you both share in the gains or losses. The higher your tax rate, the bigger share of the partnership (and resulting gains/losses) that the IRS (and state department of revenue) owns. For high income earners, this rate can be as high as 50%. Contrast this to a brokerage account where your maximum federal long-term capital gains tax rate is 23.8% and most taxpayers pay 15% or less.
We don’t encourage that any retail investor buy individual stocks because of the practical implications and empirical evidence but we also recognize that people enjoy gambling in Las Vegas even if there is a large expected loss. Here’s our advice: If you own a stock in a traditional IRA or 401(k) that you expect to appreciate significantly and that you expect to hold for more than a year, you will likely save significantly on future taxes by selling it in the IRA and immediately buying the same stock in a tax free Roth (best location) or brokerage account (second best). That is, unless you just enjoy sharing more of your gains with your IRA partner – the taxman.
Mistake: You own the same stock or fund in all of your accounts.
We often see statements of prospective clients where the investor has five different accounts that all essentially mirror one another. This is terribly inefficient. First, it means paying any brokerage or trading costs (both buys and sells) five times instead of once or twice (which can be profitable for the broker). More importantly, it means that the investor or financial advisor is ignoring the different tax characteristics of each account and significantly impairing the after-tax rate of return. The structure where each account mimics the other accounts is simply a lazy and costly approach to investing.
Mistake: You own hedge funds or tax inefficient alternative investment in your brokerage account while using your IRA to own stocks and bonds.
Hedge funds and alternative investments can certainly be useful diversifiers but many types (arbitrage, macro, tactical, managed futures, etc.) are tax inefficient and often have slow K-1 tax reporting. For most investors, it makes sense to purchase any tax inefficient hedge funds in IRA accounts where there is room before owning a hedge fund in a brokerage account.
Mistake: You ignore asset location despite being 1) subject to high income Medicare B premiums; 2) an early retiree who is potentially eligible for health insurance subsidies; or 3) a parent seeking to qualify for FAFSA-based student aid.
The tax costs of ignoring asset location are generally even more harmful for people in situations such as these. In addition to paying higher taxes, many families that ignore asset location are forced to pay thousands per year in additional Medicare premiums not because they had the wrong investments but merely because they owned their investments in the wrong accounts. Locating investments in the wrong accounts can also mean reduced student aid or forgone health insurance subsidies.
The mistakes outlined above are generic in nature and sometimes the facts or circumstances may argue differently. For example, someone who has only Roth IRA assets may be justified to own bonds in a Roth account. Alternatively, there are some tax efficient alternative investment strategies that may be well-suited for a brokerage account. The point is to highlight some of the most prevalent examples of how investors organize their financial kitchens in inefficient and nonsensical ways to help avoid making the same mistakes.