Tax Efficiency

How correct tax placement can save you literally thousands on taxes every year

Tax efficient fund placement is an often underrated topic. The goal of the tax efficient fund placement is to minimize taxes within your investments, and select the right account for those investments.

But how much does that actually matter?

Vanguard’s research finds that a thoughtful asset location strategy can add significantly more value than an equal location strategy. The value added typically ranges from 5 to 30 basis points of after-tax return, depending on circumstances (e.g., income, portfolio size).

Investors generally have access to different account types, including:

• Tax-free accounts (Roth IRA, Roth 401k)

• Taxable brokerage accounts

• Tax-deferred accounts (401k, 403b, Traditional IRA)

If you are an employee that may not have access to a retirement plan, you could perhaps consider a Solo 401k if you have “side hustle” business income.

Generally, if your investments are all in tax-deferred or tax-free accounts, fund placement will not make a huge difference for you. That is because these accounts already come with tax efficiency.

If that’s your case, 2 things become important though:1.

1. Consideration between pre-tax (e.g., Traditional 401k) or after-tax account (Roth 401k). Put simply, this decision generally comes down to your marginal tax rate now vs. marginal tax rate in the future (which isn’t something easy to predict due to the ever-changing tax landscape).

2. Account allocation. It becomes equally important where exactly you are investing. Roth accounts grow tax-free and qualified withdrawals are tax-free. You likely don’t want to hinder that growth by choosing conservative assets (like fixed income, MMF, etc.).

Tax-efficient fund placement becomes extremely important when you also have a taxable brokerage account, along with tax-advantaged accounts. Many funds pay dividends and distribute capital gains if placed in your taxable brokerage account. At the end of the year, you receive a 1099 with that income and must pay taxes on the dividends and certain distributions.

One thing to call out from history is that you generally shouldn’t hold Target Date Retirement mutual funds (or any “proprietary” funds) in your brokerage account. This is because unexpected redemptions could cause a huge tax bill.

You may remember a Vanguard 2021 fiasco where Vanguard opened an institutional TDF to more investors (lowered the minimum investment from $100M to $5M), which caused smaller retirement plans to sell out of individual funds and move into the institutional fund. This triggered massive unexpected capital gains for anyone invested in the individual funds if held in a brokerage account.

All of those unnecessary taxes could’ve been avoided by:

• Choosing investments that don’t distribute many dividends or capital gains

• Choosing passively managed investments (low portfolio turnover)

• Placing them in tax-advantaged accounts

Let me give you a simple example:

Let’s say you are in a 22% federal tax bracket and a 5% state tax bracket, and you have some money invested in a dividend fund like Schwab US Dividend Equity ETF (SCHD). SCHD dividends are generally qualified, which means that the dividends get preferential treatment at a 15% federal tax rate for this investor.

The dividend yield is 3.43%. Considering the tax rates, the tax drag is (15% + 5%) * 3.43% = 0.686%.

To put this in perspective, a $10,000 investment will yield ~$343 in annual dividends. The tax impact on that investment will be $60.86.

Of course, if that money was in a Roth IRA, you would pay $0 in taxes on dividend distributions. Alternatively, this is something you may need to decide whether a dividend-focused investing strategy is the right one for you. For example, a Total US Stock Market ETF could have almost 3x less tax drag, and potentially more growth.

As someone in their 20s (who is subject to the Net Investment Income Tax) my focus is 100% on a growth investment strategy, rather than income generation. However, for someone in their 60s, that strategy could be different (even though selling shares for capital gains is better from a tax timing point of view).

A few more important points:

REIT stocks/ETFs are the least tax-efficient asset class to hold in a brokerage account because their distributions aren’t qualified, so you pay more tax (even though it may qualify for a 199A deduction).

Stocks that don’t pay dividends are the most tax-efficient to hold within your taxable account (Adobe, Amazon, Netflix, etc.). However, holding individual stocks may not be the best strategy from an investment and diversification standpoint.

A big benefit of a taxable account is that the money is always easily accessible (liquidity), and you can control your withdrawal timing. While there are strategies that allow you to withdraw from retirement accounts before age 59 (like Rule of 55, 72(t) SoSEPP, Roth conversions), a brokerage account is more flexible. Therefore, analyzing the contributions and investments that go into this account is crucial.

I hope you enjoyed this one!

Chat next week!

MC, CPA