Investors are often preoccupied with generating attractive returns and managing risk in their portfolios. However, one aspect that should not be overlooked is the tax efficiency of our investments. Diversified portfolios hold a wide range of investments with different asset classes/securities having different return and tax efficiency characteristics. Tax-efficient asset class placement can have a significant impact on long-term wealth accumulation and should be an integral part of any investor’s strategy. This is a strategy that we, at Meira, have regularly used over the years.
Why Tax Efficiency Matters: The primary goal of tax-efficient asset class placement is to minimize the tax burden associated with investment returns. By strategically locating investments in the appropriate account types, such as taxable (e.g., a brokerage account), tax-deferred (e.g., an IRA or 401K/403B account), or tax-free accounts (e.g., Roth IRA account), we can potentially maximize after-tax returns and enhance our wealth accumulation over time. Several well-regarded studies—especially one in 2013 by Blanchett & Kaplan—demonstrate that an investor could expect an additional 23 basis points of return by utilizing an asset location strategy (see definition below).
- Asset Location Strategy: Asset location refers to the deliberate placement of assets across different types of investment accounts to optimize tax efficiency. This strategy involves considering the tax treatment of various asset classes and assigning them to the most appropriate accounts. For example, assets that generate regular taxable income, such as bonds or high-dividend paying stocks, are typically best held in tax-advantaged accounts, whereas tax-efficient investments like index funds or tax-managed funds may be suitable for taxable accounts.
- Tax Diversification: Similar to diversifying across asset classes, tax diversification involves diversifying across different account types. By spreading investments across taxable, taxdeferred, and tax-free accounts, you gain flexibility in managing your tax liability during retirement. This strategy allows for tax-efficient withdrawal strategies and can potentially reduce the impact of future tax law changes.
- Your Personal Situation and Goals: Here’s the catch—in order to know where the highest expected tax costs will occur, it helps to know (in advance) what your future taxes and returns will be. Without a really accurate crystal ball to help us peer into the future, it can be really hard—but, we believe that undertaking a detailed analysis of your personal situation and goals is still well worth the effort.
Michael Kitces, one of our profession’s thought leaders, suggests the following key principles to consider for tax-efficient asset class placement:
- Asset location should focus on maximizing after-tax returns rather than simply minimizing current taxes.
- Asset placement decisions should consider the investor’s time horizon, tax rates, and the type
of investment accounts available.
- The investment mix within each account should be designed to complement the overall
portfolio allocation while maintaining tax efficiency.
Here is an illustrative chart depicting a sample tax-efficient asset class placement strategy:
We believe that tax-efficient asset class placement is a critical component of successful portfolio management. By considering the tax implications of different asset classes and strategically locating investments across various account types, you can enhance after-tax returns and potentially achieve your long-term financial goals more efficiently. One of our goals in managing our clients’ investment portfolios is to use a tailored strategy that optimizes tax efficiency—helping our clients to minimize unnecessary tax burdens, where possible, and keep more of their hard-earned wealth in-hand.