Finance 101: Tax-efficient accounts

There is such a thing as a free lunch.

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Over the past several years, the world of personal investments has moved steadily toward lower costs. The greater adoption of things like index mutual funds and exchange-traded funds (ETF) has made it significantly less expensive for investors to invest their savings. Where the typical stock mutual fund often charged 1 percent or more to manage your money, these newer funds charge one-tenth of that. The easiest way to improve your returns was by simply paying less. And given the challenges many savers face, the additional growth from lower costs could make a consequential difference in what you ultimately ultimately have saved at retirement.

So lower costs are an unmitigated good. But at this point, costs can only drop just so much, and then the difference will be so small as to be meaningless. So if you haven’t availed yourself of these lower costs, you should consider doing so, especially in any tax-deferred accounts like a 401(k) or an IRA. It’s basically a free lunch. It’s a free lunch in a world where most lunches are not.

Are there any other investing and saving free lunches that can be had? Yes, there are. It won’t be quite as simple as just switching the funds in your IRA, but there are benefits for many investors by looking at the tax side of investing. It is a concept sometimes called asset location.

Most people have a basic grasp of the idea of asset allocation, the mix of stocks and bonds you choose to hold. It determines the majority of what returns you might get, in line with what risks you can live with. Asset location seeks to invest your money in the ways that will give you the best after tax returns. In the end, all we actually can spend is the money we have after taxes are paid. So it pays to look at tax efficiency.

For those people who have both taxable and tax-deferred accounts, there is an opportunity to have your money be more tax-efficient and enjoy another free lunch. And that is where asset location comes in.

The easiest way to view asset location is by asking what investments should be held in taxable and tax-deferred accounts — literally what investments go where, depending on the account’s tax treatment.

A taxable account produces after-tax savings that can be invested in stocks, bonds, a full range of mutual funds, or even in cash. If you are invested in mutual funds, then you can create taxes by either receiving dividends and capital gains distributed by those funds, or by selling that fund when it has has risen in value. In a tax-deferred account, those same events do not create any taxes until the money is actually withdrawn from the account in the future.

The problem is that many people hold investments in taxable accounts that create taxes every year. And every year we must pay the IRS is a year we lose the benefit of the compounding of that money. Corporate bond funds, real estate investment trusts, high-yield bonds, and high-yield dividend stocks are a few of the securities that create this issue. And there is nothing wrong with these investments. It’s just that they should be located in our tax-deferred accounts. By doing so, we shelter that income from most current taxes, and allow for more compounding over time.

So what do we do about our taxable accounts? Assuming they have a similar long-term horizon as our tax-deferred accounts, we would look to hold stock investments here. And not your typical actively managed stock funds. These create regular tax events due to capital gains and dividends, and so should be avoided. We should consider either stock index mutual funds or exchange-traded funds invested in stocks. And why?

Because these vehicles are far more tax-efficient. They don’t buy and sell with the frequency of active mutual funds, so they rarely distribute capital gains to be taxed. And ETFs have an additional tax benefit. They can change the stocks they hold, even ones that have risen in value, without triggering capital gains. They do this by using an “in kind” exchange, which allows them to avoid the capital gains. We will still be subject to capital gains taxes in the future on the gains in our stock investments, but those gains have mostly been tax-deferred, and will be subject to lower long-term capital gains taxes versus higher income and short-term capital gains taxes. It’s a win for tax efficiency.

So if we wanted to take advantage of these tax efficiencies, we would, generally, hold our stock investments in our taxable accounts, ideally index funds and ETFs, and our income-oriented investments in our tax-deferred accounts. But we need a further step to make this not only tax-efficient but to also work with our asset allocation, our personal mix. This isn’t a simple exercise, but can be accomplished with some effort, and perhaps professional help.

I’ll offer the following example to help illustrate this idea. If you had $200,000 in a 401(k) and $50,000 in an after-tax account and your portfolio mix is 60 percent stock and 40 percent bond, you would consider the following: All $50,000 in the taxable account is in a stock ETF, ideally in stock from all around the globe. The $200,000 in the 401(k) would be split $100,000 into diversified stock and $100,000 in diversified bond and income investments. By doing so you have positioned your accounts for lower current taxes, and thereby keep more of your money working for you.

It should be worth the effort. Before making big changes in your investments seeking a more tax-efficient approach, speak with a tax advisor. And you just might find a little free lunch out there.

 

John Kageleiry is a business writer and financial planner. Read more finance columns at veriumplanning.com. Have a question for “Finance 101”? Email it to john@veriumplanning.com.