The second key factor within our control that indexers love to stress is the ability to control fees - both fees with your financial advisor and fees within a fund as measured by its net expense ratio. Studies have shown that minimizing fees maximizes returns; even seemingly small differences (such as 0.4%) add up over the course of several years and you should do everything in your power to get the lowest cost investment to fulfill your asset allocation. The third significant decision within our control is the actual security selection. Although for indexers this point is not terribly interesting as we simply choose a fund that offers one of the lowest fees and fulfills the particular asset class we desire.
That brings me the fourth and final aspect of investments in which he have control over - minimizing taxes in our investments. We can do this by having a logical asset location - that is, which investments we choose to hold in taxable accounts and which we hold in tax-advantaged (401k, Roth IRA, etc.) accounts. While we certainly can't control what the government will do in the future to tax rates (and it would be a futile affair to attempt to predict such decisions), we can exploit how Uncle Sam deals with long-term capital gains and things of that nature to minimize the amount the US government takes from our investment gains. Small differences in taxes can compound in huge figures over the long-term and investors would be wise to consider the tax efficiency and placement of their investments to reduce their tax burden. Avoiding (or at least minimizing) certain taxes is one of the most important strategies to maximize long-term growth of one's investments, but is a topic that is, unfortunately, frequently glossed over in articles and discussions on portfolio management. As will be evidenced in this post with evaluations of after-tax final portfolio values based on asset location, the difference can be stark. This is a topic that shouldn't be brushed aside.
A Basic Primer on the Rationale
Your tax burden varies largely based on the type of investment as well as the investment style and turnover of the particular fund in question. In essence, the taxes you're responsible for depends on the taxable distributions and the rate on those. This can vary based on if dividends are qualified, how often a fund distributes capital gains, and other factors. The basic premise behind tax-efficient investing is to place your efficient investments in taxable accounts (and thus you won't lose as much to taxes) and your inefficient investments in tax-advantaged accounts (since you have no tax liability until distributions, or not at all if we're talking about Roth accounts).
As a general rule, bond funds are tax-inefficient because the gains they generate are all taxed as ordinary income and are subject to your marginal income tax bracket. (Although municipal bonds have no such restriction, but typically offer lower yields to compensate). REITs, likewise, are required by law to distribute at least 90% of their income as dividends, which is overwhelming at the non-qualified divided rate. Thus, although REITs are traded as stocks, they too are extremely tax-inefficient.
While stock funds are generally efficient, if they are actively managed and have a high turnover rate, it may be possible that they generate a lot of short-term capital gains. Likewise, a fund that pays high dividends (like many value funds do) may not be as efficient. Foreign funds typically are quite tax efficient since they are eligible for the foreign tax credit.
Hypothetical Scenarios
While the general feeling for indexers is "stocks in taxable, bonds in tax-advantaged" that is not always the case as Rande Spiegelman for the Schwab Center for Investment Research explains in his report "Location, Location, Location: Dividing Your Portfolio between Taxable and Tax-Advantaged Accounts." He summarizes his findings in table form as follows:
Spiegelman poses two hypothetical scenarios for two different investors. You can read his assumption on page 2 of the report, but the first case involves "Tishana" who is in the 40% combined marginal bracket and has a portfolio value starting at $200,000 (50% in taxable, 50% in tax-advantaged). In the first portfolio (Portfolio A), Tishana places her highly efficient stocks in her taxable accounts and her bonds in tax-advantaged accounts. In the second portfolio (Portfolio B), Tishana places her bonds in taxable and highly efficient stocks in tax-advantaged.
Years | Total Portfolio A | Total Portfolio B | Advantage (Disadvantage) of Portfolio A |
5 | $216,232 | $204,087 | $12,145 |
15 | $387,030 | $346,127 | $40,903 |
30 | $975,188 | $846,486 | $128,702 |
40 | $1,841,668 | $1,629,675 | $211,993 |
As you can see in the above, Tishana would have more than $210,000 more in her final portfolio value after 40 years of investing if she practice tax-efficient placement of her investments. $210,000! That's certainly not an insignificant amount of money; it's more than her beginning portfolio value and more than 10% of her final portfolio value. Would you want to pay $200,000 more in taxes over 40 years simply because you don't want to practice tax-efficient investing? Of course not.
Next in the article, Spiegelman proposes a situation in which Tishana instead invests in actively managed stock funds in taxable and bonds in tax-advantaged. In that case, while Portfolio A outpaced Portfolio B in the 5, 15, and 30 year timelines, Portfolio B actually had the higher value after 40 years to the tune of $105,000. By the way, Portfolio A when utilizing actively managed funds ended at $1,524,169, a full $317,499 less than if Tishana had used tax-efficient index funds. And that's when assuming the actively managed fund performed identically to that of the index fund, something most actively managed funds fail to do. Even giving the active managers' the benefit of the doubt on that, the fund has to not only outperform the benchmark to break even because of higher fees, but also because of higher taxes. Yet another reason to go the passive approach! Again, such a decision could save you huge amounts over the long-term.
The article then discusses Sam who has a lower 30% combined marginal bracket. In Sam's case, the difference isn't as severe since he loses less to taxes in general so doesn't need to concern himself as much. Still, the advantage for Portfolio A when using over 40 years is $96,621, which is a quite considerable sum. In the case wherein Sam uses actively managed funds, Portfolio B outpaces Portfolio A after 30 years. Thus, if you absolutely insist on using actively managed funds (which I do not recommend), then you should consider the turnover and management strategy of the fund to determine the best placement, argues Spiegelman.
Likewise, Vanguard has a nice report worth considering titled "Asset Location for Taxable Investors" written by Colleen M. Jaconetti in 2007. Jaconetti concludes the following:
If an investor’s primary goal is to maximize after-tax return, then, in general, an optimal portfolio, from an asset location perspective, would hold broad-market index equity funds/ETFs or tax-managed equity funds in taxable accounts and taxable bond funds in tax deferred accounts. This assumes the investor is willing to forgo owning active equity funds (or other tax-inefficient investments), unless space in his or her tax-deferred registrations allows for it.
Jaconetti also proposes hypothetical scenarios similar to the Schwab study above to illustrate this point in real dollars. Such scenarios are helpful to the average investor to actually associate such decisions with real-dollar amounts as opposed to simply learning about these theoretical rules of thumb. All the same assumptions are made for the first three scenarios as stated on page 2 of the report.
In the first scenario, highly efficient index equity funds are used in taxable account and taxable bond funds are in tax-deferred. The post-liquidation value after 10 years is $1,694,671. In the second scenario, taxable bond funds are used in taxable accounts and index equity funds are used in tax-deferred accounts. In this case, the portfolio grows to $1,531,413. As you can see, this is considerably less than the first scenario. In the third scenario, the investor utilized municipal bond funds in taxable accounts (which are tax-free) and index equity funds in tax-deferred. Such an example grows to $1,583,088. While this is better than the second option, it still lags the first scenario considerably.
In scenario four, there are a few different assumptions as stated on page 4. In this case, the investor utilizes active equity funds in taxable and taxable bonds in tax-deferred accounts. Such an account has a post-liquidation value of $1,623,108 after 10 years. It is better than Scenarios 2 and 3 suggesting that even if you have actively managed funds, you should still place them in taxable. This conclusion seemingly contradicts that from Schwab, but if you look at the actual Schwab report, he came to the same conclusion for the 15-year timeframe (closest to the 10-year that Vanguard considered). It wasn't until 30 or even 40 years where the opposite conclusion was delivered. While scenario 4 beat scenarios 2 and 3, it still lags the first one. Yet another piece of evidence to support the idea of investing in index funds.
In the end, after ten years, Scenario 1 in which the investor utilizes tax-efficient index funds in taxable accounts and taxable bonds in tax-deferred performed the best after taking taxes into consideration. Scenario 2 lagged by more than $163,000, while Scenario 3 trailed by $111,583, and 4 was $71,563 behind, suggesting that such a location decision is less important for those implementing actively managed funds. As stated at the onset, scenario 1 optimizes returns.
Other Research Reports
Dammon, Poterba, Spatt, and Zhang from CMU, MIT, CMU, and UT-Dallas reached the same conclusion as the Vanguard report utilizing arbitrage arguments in their 2004 TIAA-CREF Paul A. Samuelson Award-winning paper, which they discuss in a research dialogue. They conclude:
Using arbitrage arguments, we showed that holding equities in taxable accounts
and bonds in tax-deferred accounts is the optimal asset location strategy even if capital gains are realized and taxed on an annual basis, as long as the tax rate on capital gains is less than that on interest income. This implies that even actively-managed mutual funds that generate large capital gains (losses) each year should be held in taxable accounts and bonds in tax-deferred accounts. The asset location decision is a matter of indifference only if capital gains are fully taxed each year (i.e., no deferral) and dividends, capital gains, and interest are all taxed at the same rate.
It appears that that Schwab came to a different conclusion as to where to place actively managed funds (and that's the only significant difference) than Vanguard and the above academics due to different assumptions that you cannot predict. (Although Schwab came to the same conclusion over shorter-time frames. Just not the 40-year hypothetical growth scenario). This is yet another reason to hold index funds - you know what you are getting and can manage it in a way to confidently minimize taxes. This much is sure, though - placing tax-efficient stock funds in taxable and bonds in tax-advantaged accounts is indisputable and can save you a boatload of cash. These investors also single out REITs as stock investments that make the most sense in tax-advantaged accounts. Of course, tax-exempt bonds should also be held in taxable accounts.
William Reichenstein, the Pat and Thomas R. Powers Chair in Investment Management at the
Hankamer School of Business at Baylor University, brings up yet another point in his paper "Asset Allocation and Asset Location Decisions Revisited." He concludes that not only is their an optimal asset locations as discussed above, but that the profession in general has been "miscalculating an individual's asset allocation, and the measurement error can be substantial. Asset allocation should reflect after-tax funds because goods and services are purchased with after-tax money." This is quite an interesting point that will be revisited in the future post, but I think it's important to note that if your tax-advantaged accounts are largely bonds and your taxable accounts are filled with stocks, then your intended asset allocation may actually be out of whack with the after-tax value of such investments and a tax-adjustment may be prudent.
Hankamer School of Business at Baylor University, brings up yet another point in his paper "Asset Allocation and Asset Location Decisions Revisited." He concludes that not only is their an optimal asset locations as discussed above, but that the profession in general has been "miscalculating an individual's asset allocation, and the measurement error can be substantial. Asset allocation should reflect after-tax funds because goods and services are purchased with after-tax money." This is quite an interesting point that will be revisited in the future post, but I think it's important to note that if your tax-advantaged accounts are largely bonds and your taxable accounts are filled with stocks, then your intended asset allocation may actually be out of whack with the after-tax value of such investments and a tax-adjustment may be prudent.
To conduct such adjustment, simply multiple the pretax values in tax-deferred accounts (401k, Traditional IRA, etc. not Roth accounts) by 1 minus the expected tax rate during retirement. Taxable accounts are also subject to capital gains taxes so an adjustment there may also be wise (such as adjusting for the 15% long-term capital gains tax for your stock gains). There is still some debate in investment circles about this approach, though, and many state that investments don't care where they are housed and thus calculating asset allocation percentages by adjusting for taxes is unnecessary.
To get back to the main point of the post, Reichenstein holds somewhat of a morphed view of the Schwab report and TIAA-CREF award-winning paper above. While he agrees that bonds should be tax-advantaged and stocks should be in taxable accounts, he also posits that such a decision is much more important for a passive investor than to an active investor. He also concludes that if one absolutely insists on holding bonds in taxable accounts, then one should adjust his or her asset allocation to have a relatively large bond holding. That is, such decisions should not be made in a vacuum and instead the optimal asset allocation and asset location decisions should be made jointly.
In yet another paper published in February 2006, "Trends and Issues: Tax-Efficient Saving and Investing," Reichenstein highlights a few key points. The first being that individuals should maximize their contributions to tax-deferred and after-tax accounts as much as possible as they all "allow for tax-exempt growth on their after-tax values." He again brings up the point of miscalculating one's asset allocation by not adjusting for after-tax values and thus individuals "overstate the allocation to the dominant asset class held in tax-deferred accounts." This is the paper you should consult if you want a clear explanation as to how to calculate your "true asset allocation" as I briefly described above.
For a more simplified description of the above including various investment choices, one can consult the Bogleheads wiki article on this topic. The wiki summarizes the strategy as follows:
- Choose your basic asset allocation (stocks/bonds/cash) before worrying about taxes.
- If possible, put your most tax-inefficient funds in your tax-advantaged accounts (IRA, Roth IRA, 401(k), 403(b), etc.).
- If you would have to hold a tax-inefficient fund in a taxable account, consider a more tax-efficient alternative, such as a stock index fund rather than an active fund.
There is also a helpful graphical representation of how efficient various asset classes are as reproduced below.
That is certainly a helpful graphic to refer to when making asset location decisions.
Conclusion
While devising an investment plan, establishing a reasonable asset allocation based on your risk tolerance, objectives, and timeline is probably the single most investment decision you can make. Security selection to minimize fees and optimize returns while fulfilling a particular asset class also is vital in your investment well-being. In addition to those two factors, however, the decision to implement a tax-efficient investment plan to minimize taxes has proven to provide a significantly larger nest egg. The effect of taxes on one's portfolio should not be understated and one must consider the tax-efficiency of their investments when considering asset location. This is certainly an area that is often neglected but shouldn't be as the ramifications are profound. Studies utilizing historical data on the distributions and capital gains of investments as well as the current tax laws in place lead to an overwhelming benefit to the investor to place taxable bonds in tax-advantaged accounts and highly efficient stock funds in taxable accounts. Notable exceptions to the stocks in taxable accounts include REITs and actively managed funds with high turnover.
The location of your investments is vital to minimize taxes and maximize your after-tax portfolio return. I can assure you that you won't be sorry for considering tax-efficiency in your investment plan. It could mean literally hundreds of thousands of dollars more in your name when all is said and done.
Sources
Dammon RM, Poterba J, Spatt CS, Zhang HH. "Maximizing Long-Term Wealth Accumulation: It's Not Just About 'What' Investments To Make, But Also 'Where' To Make Them," TIAA-CREF Institute. 2005.
Jaconetti, Colleen. "Asset Location for Taxable Investors," Vanguard Investment Counseling & Research. September 12, 2007.
"Principles of Tax-Efficient Fund Placement," Bogleheads Wiki. 2010.
Reichenstein, William. "Asset Allocation and Asset Location Decisions Revisited," The Journal of Wealth Management. Summer 2001.
Reichenstein, William. "Tax Efficient Saving and Investing," TIAA-CREF Institute Trends and Issues. February 2006.
Spiegelman, Rande. "Location, Location, Location: Dividing Your Portfolio between Taxable and Tax-Advantaged Accounts," Schwab Center for Investment Research. June 2004.
Jaconetti, Colleen. "Asset Location for Taxable Investors," Vanguard Investment Counseling & Research. September 12, 2007.
"Principles of Tax-Efficient Fund Placement," Bogleheads Wiki. 2010.
Reichenstein, William. "Asset Allocation and Asset Location Decisions Revisited," The Journal of Wealth Management. Summer 2001.
Reichenstein, William. "Tax Efficient Saving and Investing," TIAA-CREF Institute Trends and Issues. February 2006.
Spiegelman, Rande. "Location, Location, Location: Dividing Your Portfolio between Taxable and Tax-Advantaged Accounts," Schwab Center for Investment Research. June 2004.
