Advanced Strategies for Investment Taxation
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.
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.
Broad stock index funds
Low-turnover stock funds
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.
I often see clients needlessly holding muni bonds. If they also hold stocks in the tax-deferred account, there is a way to both lower risk and increase return. As an example, the Vanguard Intermediate-Term Tax-Exempt Admiral Bond Fund (VWIUX) yields 2.16% as of April 3, 2019, while the Vanguard Total Bond Index Fund Admiral (VBTLX) yields 2.96%. The former has substantial risk with $1.6 trillion of unfunded liabilities, while the latter is roughly 64% backed by the U.S. government. By selling the muni fund in the taxable account and buying a stock fund and then selling the same amount of the stock fund in the tax-deferred account and buying the Total Bond Fund, returns rise while risk falls.
Now let’s add the Roth. Under current law, taxes will never be paid on the principal or earnings. So a REIT is perfect for the Roth, if the client is to hold REITs. While the 2017 Tax-cuts and Jobs act lowered the taxes on REITs with the 20% qualified business income (QBI) deduction, it’s still likely that the dividends from REITs will be taxed at higher rates than qualified dividends for stocks. Since REITs have a good chance for significant growth and are relatively tax-inefficient, REITs are ideal for a Roth
Let’s take as an example a client with $1 million who lives in a state that has income taxes. The client wants $300,000 in U.S. stocks, $150,000 in international stocks, $50,000 in REITs and the other half in fixed income. They currently have $500,000 in a taxable account; $400,000 in a tax-deferred account, and $100,000 in a tax-free Roth account. I might design it in this way:
- Taxable account
- $300,000 Total U.S. stock fund
- $150,000 Total Int’l stock fund
- $50,000 Treasury or TIPS fund
- Tax-deferred account
- $400,000 Total Bond and or CDs.
- Tax-free Roth
- $50,000 REIT
- $50,000 Investment-grade bond
I located the TIPS fund in the taxable account because Treasury interest is state tax-exempt, and put the investment grade bond in the Roth as it has a higher distribution. If one believes that junk bonds have a role (I don’t), then it could be placed within the Roth.
Admittedly, this is an oversimplification as each of these tax wrappers have different values per dollar. Roth accounts are typically the most valuable and tax-deferred are the least valuable, if taxes will eventually have to be paid on the entire amount.
Lastly, if you have to hold stocks in your tax-deferred accounts to hit your overall asset allocation target, is it better to locate U.S. or international stocks in the taxable account? Mike Piper, author of Taxes Made Simple and the Oblivious Investor blog, says it comes out a wash. The benefit of taking the foreign tax credit by locating in the tax-deferred account is offset by international’s higher dividend yield and lower proportion of qualified dividends.
Deciding on selling the expensive fund with a large taxable gain
I tell clients I can’t just build a theoretically correct portfolio in a world without taxes. So do we sell the expensive underperforming dog? In general, clients should think of their future tax liability from the unrealized gain as an interest-free loan.
As an example, say the client has $50,000 in a fund with a 0.34% annual expense ratio with a $30,000 gain and their marginal tax-rate is 30% between federal and state. They would owe about $9,000 in taxes if they sold. That interest-free loan might be worth about $360 a year if we impute a 4% interest rate (4% x $9,000). If the better fund had a 0.04% expense ratio, they could save about 0.30% a year on the full $50,000 which equates to about $300 a year. Thus, I may not recommend selling. But that fund might be tax-inefficient, generating annual capital gains anyway, so consider selling. Many funds get into a death spiral generating large gains as fundholders flee and the fund must sell assets at large gains, passing them on to remaining shareholders.
Also, take into account the age and financial situation of the client. If they are financially secure with a short life expectancy, it may be worthwhile to hold on to it so the heirs can get the step-up basis under current law. If one does keep the fund, turn off dividend reinvestments. I tell clients to stop buying more of the fund they wish they hadn’t bought in the first place.
Contributing after-tax dollars to tax-deferred accounts
I’m often asked by clients whether they should contribute non-tax-deductible contributions to their tax-deferred IRA accounts. The benefit is that they can defer the taxes owed from the income. What this does, however, is co-mingle pre-tax and post-tax money, eventually converting future earnings that would have likely been taxed at a lower rate (qualified dividend and long-term capital gain) into ordinary income when withdrawn. Not only that, one must keep track of the after-tax contributions for decades and pro-rated withdrawals. Otherwise, the IRS will be taxing that after-tax contribution twice.
I’m often asked about Roth conversions or whether to use a Roth or traditional IRA. There are some common misconceptions including the one I’ve heard the most – if you have more than 10 years until withdrawal, Roth is superior.
It has nothing to do with time. The decision is mainly based on the client’s current marginal tax bracket versus the tax bracket when one needs the money. If it is higher in the future, the Roth will be superior. On one hand, earned income is less or zero in retirement arguing traditional. On the other hand, considering marginal tax rates are lower than they have been for some time, and our record national deficit are looming, tax rates could very well be higher in the future, suggesting the superiority of Roth.
Because we don’t know the future, a form of tax diversification is to have three pots of money – taxable, tax-deferred, and Roth. It isn’t an either/or decision.
There are two strong arguments for Roth conversions if a client is in one of two situations. They may have some after-tax dollars in their traditional IRA. If, for example, the client has a $20,000 IRA with $6,000 in after-tax contributions, they can convert with only $14,000 of income and solve the problem previously noted on after-tax contributions to tax-deferred accounts. Understand, however, that the IRS takes into account all IRAs for each individual. If that same person also had a second $100,000 IRA with no after-tax contributions, $19,000 of that $20,000 would be taxable as the basis is prorated across all of that individual’s IRAs.
The second is that many states offer an annual exemption for tax-deferred withdrawals later in life. In Colorado, for instance, each individual between the ages of 55 and 64 can convert $20,000 a year without owing state taxes. At age 65, it increases to $24,000 annually. Because SALT taxes are now limited to $10,000 a year, this state exemption is even more valuable. Thus, it may be advantageous to do annual conversions up to the exemption maximum.
Piper notes that an advantage Roth conversions offers is that it lowers future RMDs. Also, for large estates, it can lower potential estate taxes.
Clients spend most of their lives saving and investing; withdrawal is a whole new game. As a general rule of thumb, I advise clients to spend taxable dollars first, tax-deferred next, and Roth last. But that’s a starting point and often I advise a strategy with the goal of paying taxes sooner at a lower rate than later at a higher rate.
Because I typically recommend deferring social security, clients’ taxable income usually increases beyond age 70 with Social Security income and required minimum distributions (RMDs). This could mean higher marginal tax rates.
Recognizing a long-term capital gain at a zero percent tax rate is one strategy Mike Piper calls tax-gain harvesting. For example, in 2019, a couple married filing jointly can have income up to $78,750 and recognize long-term gains without paying federal taxes. That’s the best time to get rid of those expensive funds mentioned earlier.
The second strategy is recognizing ordinary income by taking out tax-deferred money before you have to. For instance, if your marginal tax rate this year is likely to be ten percentage points lower than next year, recognizing ordinary income up to that marginal tax bracket could be beneficial. The two ways to do that are Roth conversions or just taking the money out to live on.
Both of these two strategies to recognize income impact each other so typically it is one or the other.
Eventually, clients are likely to pay more in taxes from their investments than ongoing expense ratios. But taxes are fees too. Consider some of these strategies in helping your clients. Work with the clients’ CPA and help them understand your logic. They will generally appreciate you bringing them into the picture and together you can work through how these strategies may benefit your client.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisor. He has been working in the investment world with 25 years of corporate finance. Allan has served as corporate finance officer of two multi-billion dollar companies, and consulted with many others while at McKinsey & Company.