Tax-Efficient Fund Placement and Asset Location Optimization

Optimal Asset Location

Asset Location Optimization and Tax-Efficient Fund Placement

How do you asset allocate over your multiple accounts?

First, you want to pay less in taxes. Tax-Efficient Investing becomes critical as the size of your brokerage account increases.

How can you optimize asset location? Which funds go in which accounts? How does tax-efficient fund placement improve returns? And how does it affect risk?

To understand tax-efficient fund placement and the asset allocation of multiple account types, we must understand the characteristics of the accounts. Then, we must understand asset location and what funds go where.

Multiple Account Types and Tax-Efficient Fund Placement

Let’s look at the different account types most of us have available for investing. Different “buckets” or “wrappers” hold our investments.

Taxable (Brokerage Account)

There are the taxable buckets—our brokerage and savings accounts. You pay taxes on these in dividends, interest, and short-term capital gains every year. This is called tax drag. Eventually, we pay long-term capital gains.

Tax-Free (Roth)

Next, the tax-free bucket. This is usually called Roth. You have already paid taxes on these accounts and can utilize them in the future without tax implications.

In addition, there are additional sources of tax-free money. For example, you have the basis on your brokerage investments (where you have already paid tax) and loans (on homes, life insurance, brokerage accounts, etc.), where you also get tax-free income. Finally, don’t forget your HSA.

Pre-Tax (Retirement Accounts)

Finally, there is pre-tax money. These accounts are where the rubber meets the road. IRAs, 401k, 403b, 457 plans are all taxes waiting to happen. Ticking time bombs. You don’t own these accounts outright! You own a percentage of them, and the government owns the rest. The difficulty with these accounts: future taxes are unknown, so you don’t know what these are worth!

For instance, if you have no other income, you can take money out of these accounts and fill up your standard deduction tax-free. So you put the money in and get a tax deduction—you take it out, and it is tax-free! Brilliant!

But if you have a pension and social security filling up your standard deduction and even your 10 and 12/15% tax brackets, you might pay more in taxes on these accounts in the future than you got in deductions in the past. Not cool, Uncle Sam!

Also, not cool—Required Minimum Distributions. Sam wants his money back, forcing you to take out the income in these pre-tax accounts once you turn 73 or 75.

Tax-Sheltered

Another tidbit to be tax-efficient: some of your accounts grow tax-deferred. These are also called tax-sheltered. Pre-tax accounts and, of course, tax-free accounts grow tax-sheltered. As a result, there is no yearly tax drag, which improves long-term returns.

In addition, insurance products like accumulation annuities and cash value life insurance policies also grow tax-deferred.

Finally, you can use business deductions, real estate, or farm or ranch income to shelter W-2 income.

Next, let’s look at examples of optimized and poor asset location. What does a portfolio optimized for tax efficiency look like?

What Does Optimized Asset Location Look Like?

Folks are often tempted to locate their assets equally. A poorly optimized portfolio looks something like this:

poorly optimized asset location

Above is an example of a 60/40 portfolio. Each account type– the brokerage (taxable), pre-tax (tax-deferred), and tax-free (tax-exempt) are 60/40. Total net worth is $2.5M.

Why isn’t this tax-efficient?

In the taxable account, you pay ordinary taxes on the bond income. In addition, you don’t get foreign tax credits on the international funds in your tax-sheltered accounts. Finally, there are funds with lower expected returns in the tax-free bucket! Therefore, we need to optimize asset location in our multiple accounts!

A Tax-Efficient Fund Placement Example

Tax-Efficient Fund Placement Example

Above, now you have all your international equities in your brokerage account. You can take advantage of the tax break from the foreign tax credit.

Also, all your bonds are in a tax-sheltered account with no tax drag. Finally, Roth has all equities with higher expected returns.

Note: To get to 40% fixed income, the tax-deferred account is now 100% in bonds! This lowers the future expected returns and, thus, future taxes. Required Minimum Distributions will be lower, and you can pay less in taxes in the future.

You expect more money in the Roth account BECAUSE you are taking more risk. Equities are riskier than bonds, but the money will be yours rather than shared in the future. So, you take all the risk and get all the reward.

Let’s look at another way to visualize an optimized asset location.

Another Way to Visualize Optimal Asset Location 

Visualize Optimal Asset Location

As another example of an optimal asset location, see above. Here, the entire portfolio is in one pie graph. This is an excellent example of tax-efficient fund placement!

In this portfolio, 50% of the assets are pre-tax, 40% are in a brokerage account, and 10% are Roth.

The overall asset allocation is 60% equities (blue) and 40% fixed income. Note that blue (equities) has several different types of index fund ETFs, while the 40% fixed income is broken out into several additional funds.

The brokerage account represents 40% of the portfolio in the top right corner. It is tax-optimized in international equity ETFs. The remaining is allocated to US equity ETFs. Remember, you want to use tax-efficient ETFs in the brokerage account rather than mutual funds, which may pay out yearly income (via forced distributions) you don’t want.

In the Roth, 10% of the portfolio is entirely in equities. Consider a small-cap value fund or other “tilt” with higher future expected returns. Whether there are short-term capital gains, ordinary income, or a significant turnover in this tax-sheltered account doesn’t matter.

Finally, the pre-tax portion- 50% of the portfolio total. The last 10% of equities (blue) can be in tax-inefficient equity funds such as REITs. And then, this is where your fixed income goes. Say 20% total bonds, 12% short-term bonds, 5% TIPS, and 3% cash. Or whatever.

With that, how do you set up your portfolio for tax perfection?

Tax-Perfection and Considerations for Retirement 

Let’s get set up for tax perfection! When making money, put it away tax-efficiently in your three types of accounts. The goal is good tax diversification with investments in all three account types.

Then, have a long Tax Planning Window.  Here, you convert the pre-tax to Roth while having no other sources of income and thus access to the standard deduction and lower tax brackets.  This strategy utilizes tax arbitrage, where you save taxes when deferring income but then convert to Roth when you have access to the lower tax brackets. Live off the basis in the brokerage account to minimize capital gains.

Now, you have control over your income in retirement! Take exactly what you need from the pre-tax accounts to fill up the standard deduction and the lower tax brackets. Since you minimized the size of the pre-tax accounts, Required Minimum Distributions don’t force out extra money and thus additional taxes. If extra money is needed (you don’t want to hit cliff penalties like IRMAA), steal money from the Roths.

Next, let’s quickly look at some additional tax considerations in retirement. These are breakpoints, cliffs, or other retirement tax planning goals.

Taxation of Social Security

Generally, it is challenging to prevent the taxation of social security. Income limits are low and haven’t ever been adjusted for inflation. While the Tax Torpedo is a massive concern for some who rely primarily on social security, most high-income earners should assume 85% of their social security will be taxed.

Tax Bracket Management

Here, know where your standard deduction and lower tax brackets fall so you can harvest your pre-tax money annually and optimize lower taxes. Required Minimum Distributions mess with your plans, so doing partial Roth conversions or living off the pre-tax accounts before 75 may make a lot of sense in a tax-efficient retirement income plan.

Surcharges

IRMAA can be a pain in the rear. It is a cliff surcharge, so it must be managed carefully. This will be a focus and goal for income management in retirement for most well-to-do retirees.

Capital Gains Zero Percent Tax Bracket

Below a certain income, you can harvest capital gains tax-free!

NIIT

You also may want to avoid NIIT if you are harvesting capital gains or have income above 200k/250k.

 

Scenarios Based on Portfolio Optimization

Low Tax Bracket Investors

In accumulation, low tax bracket investors should consider Roth 401k plans and fund Roth IRAs.

Middle Tax Brackets Investors

In accumulation, middle tax bracket investors need to focus on tax diversification. Have some Roth accounts, some brokerage accounts, and your more significant pre-tax account. In de-accumulation, you should assume your social security will be fully taxable.

High Tax Bracket Investors

In accumulation, high tax bracket investors defer income to pre-tax accounts. In addition, save aggressively in brokerage accounts. Then, we hope to have a good Tax Planning Window where you can access your lower tax brackets for partial Roth conversions. Live off the basis in the brokerage account to do Roth conversion. Avoid tax drag.

Investors with Pensions

Pensions are a blessing and a curse! You are blessed with the income, but you can be sure it will make your social security fully taxable and destroy access to your lower tax brackets. Folks with taxable pension income must look closely at current and future tax brackets.

Yield-Split Method of Tax-Efficient Fund Placement

Kitces codifies using dividend (and other) yield of equity funds to go even one step further down the path of tax-efficient fund placement.

You can put your value stocks in your brokerage account because they have less tax drag and put your growth stocks in a tax-sheltered account due to the slightly higher yield. Same thing with bonds. Tax-efficient treasuries can go into the brokerage account, and higher-yielding corporates go in tax-sheltered.

 

tax split method

Above is a top-drawer graph from the blog on the yield-split asset location strategy with specific funds from iShares and Vanguard. Have at it if you want to go from a three-fund portfolio to a yield-split one. If you do it well over time, your portfolio may be 6% larger (15 basis points a year in savings due to tax drag).

Conclusion- Tax-Efficient Fund Placement and Asset Location Optimization

Remember, the government owns part of your pre-tax accounts.

And tax drag: capital gains and bonds income drag returns in the brokerage account.

You can optimize your asset location if you don’t lose the big picture—risk. If you can tolerate the risk of having all equities in your taxable accounts—and don’t need the liquidity—you will pay less in taxes. If you can tolerate the risk in your Roth accounts, you will be rewarded with higher expected growth over the decades. And, if you leverage debt, you can have greater returns due to more risk.

You are usually better off placing funds with higher expected returns in Roth accounts. If you take risk in your pre-tax accounts, the government shares the risk and gets taxes on the return.

With asset location optimization—tax-efficient fund placement—you need to pay attention to the asset class’s future expected returns and tax efficiency.

Sounds like a lot? It is! Retirement income planning—tax-optimized retirement income planning—is a lot to think about.

But you need to start somewhere. If you want a bit easier, read: Visualize the 3-Fund Portfolio Across Multiple Account Types.

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7 Comments

  1. Hi DL. Sounds like you need a tax projection so that you can know how much to pull yearly from your pre-tax (or do Roth conversions). In general, you pull from the accounts like you stated, but the exception is when you can get the pre-tax accounts for lower taxes than you otherwise would in the future. Maybe read my bit on Tax Planning Window?

    • Thanks for your reply. The question I can’t seem to find an answer to, is do you leave the same investments in the accounts or do you switch to a more balanced asset allocation during deaccumulation? Do I keep mostly bonds in the pretax and small cap value and REITS in my Roth like I did during accumulation? If I spend through my brokerage (which contains total stock market and international ETF’s), then my pretax, I am left with a Roth that seems to be quite risky with its allocation. Is that not correct?

      • You are correct, and the reason you are having difficulty finding an answer is that there is no real data to help you decide. If your goal is to have the most money at the end, you would sell off all your bonds first and leave yourself with the most aggressive portfolio possible (see my bit on should you rebalance your retirement portfolio). But the reason why we rebalance is not to have more money in the end, it is to control risk. So you do need to think about when you are going to access your accounts when you do asset location. For instance, if you “need” some Roth money in 2 years, you might have very different funds in there than if you “need” the Roth in 20 years when it is passed on to your heirs. You can control risk by positioning assets in your different account-types depending on when you need them. But then the flip side is that money is fungible, so you can always adjust your portfolio balances inside your tax-sheltered accounts to keep your overall asset allocation intact (which again, is to control risk). De-accumulation is a difficult puzzle, no?

  2. One follow up: Mirror allocation would not be appropriate if you own high yielding taxable assets like REITS, high yield junk bonds… If thats the case then those should go in tax-protected space. My argument FOR a identical allocation across all accounts is for the person who owns typical low cost stock index funds and typical lower returning bond funds.

  3. Thanks for your thoughts and I agree, after-tax asset allocation is really what we should be discussing, but it it the future after-tax asset allocation which includes the future unknown tax brackets that we really want. And we cannot know the future.

    So, to keep it simple, you don’t need a mirrored asset allocation because money is fungible. Is it fungible in an after-tax equivalent? Nope! But close enough that simple wins the day!

    • Thanks for your reply! Agreed, simplicity matters. Better to find a reasonable system that you are able to stick to, then a complicated one that you aren’t. I find that mirroring my accounts is simpler for me, but if its the opposite for someone else, so be it. As you said, to get it perfect we would have to know the future, or be lucky.

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