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Five Steps to Building Tax Efficient Portfolios

The following post originally appeared in CityWire RIA magazine. While it is geared to other financial advisors, we thought it might give some insight into how we help clients build tax-efficient portfolios.

There is a very simple way for financial advisors to save their clients' money and improve their investment results, and that is building tax-efficient portfolios. For many clients, taxes could be the single biggest expense they face each year. While last year’s tax reform bill reduced tax rates overall, the top ordinary rate is still 37% and the top capital gains tax rate is 23.8%, and that’s before you factor in state income taxes.

Building tax-efficient portfolios is a multi-step process, so let’s take a look at these steps through the lens of a tax-efficient portfolio pyramid (see below). This starts with the foundational building blocks of a portfolio, and each layer adds a way to improve the tax efficiency of the portfolio. Let’s go through each level of that pyramid from the ground up.

1. Asset Allocation

This is the fundamental building block for any portfolio, whether the portfolio is tax-efficient or not. However, it is critical to develop an overall asset allocation plan for the client’s entire portfolio, not just isolated accounts. In order to build a tax-efficient portfolio properly, you need to consider all the different account types held by your client.

2. Asset Location

Once you develop an asset allocation plan for your client, you need to decide where to locate those assets. The first step for this is simply to assess what types of accounts the client has and how much of the overall portfolio is in each type of account. The general categories are taxable, tax-deferred and tax-free, although consideration should also be given to clients who also have assets in trusts, 529 plans, health savings accounts, donor-advised funds, foundations and other accounts with specific tax attributes.

The second step is to assess the tax attributes of the asset classes that you plan to use. Assets such as high yield bonds are generally the least tax-efficient because they generate ordinary income that is taxed at higher rates. Stocks are generally more tax-efficient due to the lower qualified capital gains and qualified dividend tax rates. Municipal bonds should only be held in taxable accounts, but their inclusion should be weighed against using taxable bonds in a tax-deferred account.

The final step in the asset location decision is to determine which accounts should hold which assets. You want to place the least tax-efficient assets in the tax-deferred or tax-free accounts and, conversely, the more tax-efficient assets in the taxable accounts.

However, you should also be aware of two additional factors when making these decisions. First, you want to consider which accounts will be spent first in retirement and which will be allowed to grow over a longer period. For example, a Roth IRA might be the last account your client taps in retirement. That means you’d likely want to place assets with higher long-term growth potential in that account.

You also have to be aware of investor behavioral issues, which likely prevent you from building the optimally tax-efficient portfolio. While it might make sense to put all taxable bonds in the IRA and all stocks in the taxable account, how will your client react when those accounts start showing drastically different performance numbers?

3. Investment Selection

Once you decide how much to put in each asset class and which asset class will go in which account, you need to determine what type of investments you will use. Will you be using individual stocks and bonds or mutual funds and ETFs? Will you use index funds or active managers? Low turnover investments are better suited to taxable accounts, while more actively managed strategies might be better off in a tax-deferred account. ETFs generally tend to be more tax-efficient, but there are also mutual funds that offer ‘tax-managed’ versions that might be appropriate in taxable accounts. There are many decisions to be made here, but many of them will be decided by your overall investment philosophy.

4. Maintenance

Your job isn’t done yet! There are plenty of ways to reduce your client’s tax bill on an ongoing basis through tax-efficient portfolio management. These include tax-loss harvesting if there are unrealized losses in portfolios or harvesting gains if a client is having a very low-income year. Rebalancing the portfolio back to target allocations is important, and the tax impact of that rebalancing should be assessed before any changes are made. If the client is in the accumulation phase, you should consider the most tax-friendly ways to add more to the portfolio. If the client is in the decumulation phase, you should review their tax situation each year and address their withdrawal strategy, including where to take cash to cover living expenses. Managing a client’s tax brackets – particularly in the years before the required minimum distributions begin at the age of 70.5 – can add tremendous value to their long-term plan.

5. Automation

As technology improves every year, it becomes easier to build and manage tax-efficient portfolios. There are many companies out there building software solutions that will make it easier for you to do things such as tax-loss harvesting and developing tax-efficient withdrawal strategies. Although building the algorithmically optimal tax-efficient portfolio might not be the right behavioral answer for your clients, you can still use technology to point you toward a more tax-efficient portfolio.

All in all, you don’t have to be a CPA to help your clients improve their investment outcomes through proper tax planning. While the performance of the investment markets is out of your control, taxes are not. Don’t overlook an excellent way to provide value to your clients.

-Chris Benson, CPA, PFS