Investing is simple, but taxes aren’t. As a CPA, I make portfolios as tax-efficient as possible. I advise clients that the goal isn’t to pay the least amount of taxes, but to make the most money after taxes. With fee compression eroding advisor profitability, this is one key area you can differentiate your practice and add value for your clients.

Some things are simple, like buying tax-efficient stock funds, such as index funds with little or no turnover. Other strategies are far more complex. Just about everything I’m going to cover has exceptions – and many of those exceptions have exceptions. All of this is a result of tax codes with thousand of pages. I’m going to concentrate on asset location, but will discuss the following as well:

  • When to sell the expensive fund with a taxable gain;
  • Contributing after-tax dollars to tax-deferred accounts;
  • Roth conversions; and
  • Which assets to spend first.

Asset location

I submit the following chart as a simple guideline – with two critical caveats. Asset allocation always comes before asset location. Understanding the client’s willingness and need to take risk always comes first. Second, there is a high likelihood that tax-advantaged investing will do better than taxable investing. The chart is not a recommendation to pass on IRA or 401K contributions.

Taxable Accounts

Tax-Deferred Accounts

Broad stock index funds

Taxable bonds

Low-turnover stock funds

REITs

Tax-managed funds

CDs

 

High-turnover stock funds

 

Fun gambling stock accounts


The above chart doesn’t include Roth tax-free accounts. I’ll get to this shortly. The reason to own the stocks in the taxable account is they are already tax-efficient. Dividends are taxed at the 15% or 20% rate and the capital gains taxes can be deferred or possibly even eliminated. There are three ways of eliminating taxes on those gains: Recognizing a long-term capital gain at the zero percent federal tax bracket (perhaps in retirement before taking Social Security and RMDs) currently at $78,750 for married filing jointly; Passing the stocks on to your heirs after death and allowing them to get the step-up basis; donating appreciated stock to charity.

Less efficient investments such as bonds, REITs, and high-turnover strategies benefit more from the tax-deferral and are generally better held in the tax-deferred accounts.