Taxes are a reality of life. As a result, taxes should be included in the evaluation and construction of any portfolio plan. Investors that ignore the effect of taxes on investments may end up paying higher taxes and earlier than needed. The good news is that investors have some control over when and how taxes will be generated in the investment process to reduce taxes.
Tax efficiency measures taxes generated by an investment over time. An investment’s tax efficiency depends on how it generates an investment return, whether through an increase in its price (capital appreciation) or through its periodic payments (dividends or interest income). Investments with high capital appreciation are considered more efficient while those with high dividends or interest income are considered less efficient. The determination of which lies in how they are taxed; as capital gains or added to ordinary income.
Taxes from investing also depend on account types: taxable, tax-free, or tax-deferred. Tax-efficient investments in taxable accounts have relatively low taxes. Tax-inefficient investments can defer taxes until a later date with a tax-deferred account or avoid taxes altogether with a tax-free account.
Some examples of account types with appropriate combinations of securities that minimize taxes:
Brokerage, joint, trusts
Roth IRA, Roth 401(k), Health Savings
Traditional IRA, 401(k)
Index equities, tax-exempt bonds
Actively-managed equities, REITs
Diversifying strategies, taxable bonds
Placing securities with different tax-efficiency levels into the 3 account types is asset location. This does not change an investor’s overall objective or investment risk but rather views all accounts as a single portfolio. It uses the same securities and values but will change where these securities are held among the 3 account types based on tax-efficiency.
There are several potential benefits, including:
- Higher after-tax return potential through a reduction in taxes paid for a portfolio
- Fewer trades, leading to lower potential trading costs when managing a portfolio
- Greater flexibility for the timing of tax realization
- Holistic, portfolio-level management approach that accommodates for taxes
A Vanguard study estimates the benefit of asset location to be in the range of 0% – 0.75% per year in after-tax returns. A Morningstar study conservatively estimates a range of 0% – 0.50%. As noted by Morningstar, the most significant benefits will be for investors with complex financial scenarios, a variety of accounts, and high marginal tax rates (2). MCF offers tax-efficient investing for appropriate clients to take advantage of these benefits. Contact an MCF Consultant to discuss using tax benefits in your financial plan.
1Kinniry, Jaconetti, DiJoseph et al., “Putting a value on your value,” Vanguard, September 2016.
2Blanchett and Kaplan, “The Value of a Gamma-Efficient Portfolio,” Morningstar, October 2017.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by MCF), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from MCF. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. MCF is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the MCF’s current written disclosure statement discussing our advisory services and fees is available upon request. If you are a MCF client, please remember to contact MCF, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please click here to review our full disclosure.