Investors have the ability to enhance their portfolio returns by focusing on the inputs they control. The Investor's Alpha series focuses on investor-driven inputs into the investment process and illustrates the enhancements to market returns that are possible. Peak Capital's wealth equation is simple and succinct, just like the advice one's grandparents are likely to provide over the dinner table:
Wealth = Factors You Control + Investment Return
- Savings Rate and Spending Rate
- Systematic Portfolio Rebalancing
- Proper Asset Allocation
- Tax Management
- Proper Asset Location
- Investment Expense
The secrets to generating wealth are not garnered from some archaic, esoteric black box created by rocket scientists. Simply, there is no secret formula to create and build wealth. Investors are able to control their investment outcomes by their actions. In this part of Investor's Alpha, the focus will be on maximizing returns via tax minimization by properly allocating investments amongst taxable accounts and both types of retirement accounts, Traditional and Roth. In the paper, we will illustrate how an investor can effectively and efficiently allocate capital to improve portfolio outcomes in both the accumulation phase as well as the distribution phase to increase portfolio longevity.
Peak Capital is willing to concede that going to Crazy Eddie's "Everything Must Go, Including the Dog Sale!" is more fun than sitting down with portfolio statements and a tax table from the IRS to find a deal. However, Crazy Eddie and the IRS are actually not that different. Both are insane and offer incredible discounts: 10-20% off. The big difference between the two is the emotion and the effort. It is fun to go to Crazy Eddie's; they have giant inflatable animals as well as balloons and hot dogs for the kids. The savings are seen immediately at the cash register. Unless one is doing their taxes at a used car lot, there are probably no hot dogs, no balloons, let alone a 30-foot tall inflatable gorilla. In addition, on the receipt from the IRS, there isn't going to be a line that states, "Congratulations!!! You saved $$$$ by reacting rationally in response to the tax code". A couple of simple, relatively effortless actions by an investor can reduce the tax drag on portfolio returns.
Location, location, location
The three most important aspects of real estate transpose to investing. Beginning with the basics to build the foundation of our tax-efficient house, the three main types of accounts are taxable, Traditional IRA/401(k), and Roth IRA/401(k).
A taxable account could be individually or jointly owned, as well as be in the form of a trust. Taxable accounts are funded with after-tax monies, distributions are taxed, and only gains on investments are taxed.
Traditional IRAs are retirement accounts where the money general goes in tax-free, grows tax-free, and is then taxed like income when the money is removed.
Roth IRAs are basically the opposite of Traditional IRAs in regards to taxes. The money goes in after tax, grows tax free, and the money is not taxed when it is withdrawn. Simply speaking, Roths pay tax going in and Traditionals pay tax going out.
These account structures will play a role in optimizing asset location as well as withdrawals in retirement. The entire goal of locating certain assets into a specific account type is to increase after-tax returns.
Table 1 outlines the basic characteristics of the three main accounts types. In a taxable account, any investment action will have an impact on taxes. Funding a taxable account is done with after-tax monies, which establish a cost basis that is utilized to calculate whether an asset was sold at a gain or a loss at a future date. The primary advantage of a taxable account over the two types of retirement accounts is the ability to deduct losses from other investment gains or income tax. In addition, taxable accounts allow for an increase in cost basis when the account owner dies, which transfers a tax benefit to the investor who inherits the account. In an ideal world, these advantages would never be realized. However, humans are yet to inhabit a world where no investment goes down in value and everybody lives forever.
Readers of our paper on Tax Management will be familiar with Table 2 above. This table outlines the tax rates for different types of investment income. Certain distributions are taxed differently, with the current US tax code giving preferential treatment to qualified dividends as well as long-term capital gains. The difference in how certain types of investments are taxed provides the ability to reduce taxes from investments by optimally located asset classes in accounts that minimize tax drag in order to maximize after-tax returns. Table 3 categorizes asset classes and investment vehicles into the tax category according to their common distribution type.
It should be noted that the same investment (asset class) or investment vehicle (mutual fund) may fall into several categories. Actively managed mutual funds and balanced funds are two examples of investment vehicles that can be categorized into two or more categories. For example, an actively managed stock fund could pay out non-qualified dividends, qualified dividends, and short/long-term capital gains depending upon the activity level of the fund. Balanced funds combine both stock and bond holdings and will pay both dividends and interest. The dividends a balanced fund pays out maybe qualified or non-qualified, depending upon the activity level.
It is also important to note that generally index funds do not payout capital gains; however, with the recent bull market in bonds, several bond ETFs and index funds have paid out capital gains. Table 3 should be considered more as guidelines than rigid rules, but these generalities can begin the process of effectively allocation assets among the three account types. The important takeaway is that the asset classes and investment vehicles should be evaluated periodically to determine whether they should be moved to a different account type by monitoring their primary distribution type and relative yield to other assets in the portfolio.
Table 4 outlines the additional returns - alpha - that can be captured by shielding assets that are subject to higher investment income taxes inside of retirement accounts. Admittedly, these 10-20% gains are going to be on a small amount of monies in relation to overall portfolio size. However, these small gains, when coupled with the most powerful force in the universe - compound returns - have the ability to enhance long-term portfolio returns. Vanguard's1 research estimates that tax-efficient allocation can add up to 0.75% in the first year of implementation, with a compounding effect over time. In Table 5, below we outline a simplistic example to illustrate this differential on a semi-real world example.
The scenario above assumes that the investor has a total portfolio value of $100,000, with $25,000 of space in a retirement account. We assume stocks and bonds both yield 2% and pay qualified dividends and interest, respectively. The portfolio is allocated 60% to stocks and 40% to bonds. The "Proportionate" portfolio maintains this 60/40 split in both the taxable account and in the retirement account. The "Optimized" portfolio utilizes all of the retirement space for the high tax investment. The "Optimized" portfolio reduces taxes by $39, which equates to ~0.04% extra return on the total portfolio size. If the yields on bonds increased to 4%, and holding all other assumptions the same, the tax savings triple to ~$120. This equates to ~0.12% in extra return.
Higher tax brackets and larger retirement accounts in proportion to overall portfolio size allow for more tax alpha to be captured. The two charts below illustrate these two Einsteinian conclusions. Table 6 is the same as table 5, but the tax bracket is higher. Table 7 is the same as table 5, but with $50,000 in retirement space. Both the higher tax bracket and increased retirement space scenarios show the increase in tax savings. Although the tax alpha is relatively small in relation to the portfolio, spending a little bit of time can net extra basis points of return. If the portfolio is constructed with low-cost investments, an investor might end up paying for the investment management expenses through their tax savings.
Another method to reduce interest income in a taxable account is to switch to tax-exempt municipal bonds. However, an after-tax comparison should be made, since after-tax returns are all that an investor gets to keep. For example, an investor is in the 33% tax bracket, a taxable bond fund yields 2%, and a tax-exempt bond fund yields 1.3%. Which fund will provide a higher return to the investor?
This equation can be re-written as:
In this example, the investor would keep 1.26% of the taxable yield and would have a higher return in the tax-exempt municipal bond fund. 2% (1 - 36.8%) = 1.26%. Stated from the perspective of tax-exempt yield, the taxable bond fund would have to yield more than 2.05% to provide a higher after-tax return. 1.3% / (1 -36.8%). For investors in high tax brackets as well as during periods of changing interest rates, it will be important to periodically monitor the portfolio to maximize after-tax yields.
It is important to keep in mind that the IRS is your investing partner, and it expects to make money when you make money. The great thing about having the IRS as an investing partner is that it pays you money if an asset loses value in a taxable account. In Traditional IRA accounts, the IRS bears some of the risk of investment performance, since these monies are taxed like income when distributions are taken. The IRS also bears the risk that an investor will convert an asset at a depreciated level to a Roth IRA (i.e., convert S&P 500 to Roth after a ~50% decline in 2008). The IRS does not partner with an investor in a Roth IRA account, which leaves the investor with all of the investment risk. The investor made the decision to pay off the IRS to exit the partnership when a contribution or conversion was made into the Roth. Investors should take full advantage of the strengths of their investing partner to improve portfolio outcomes through tax-loss harvesting and strategic Roth conversions.
Is the "Optimized" Portfolio Optimized?
Now for readers who are still conscious and have yet to form a lake of drool, the following question probably leaped into your mind: Should I really put all of my bonds inside of a retirement account? With lower expected rates of return in comparison to stocks, won't the size of my retirement accounts be smaller? The definitive answer to both questions is "maybe", and most likely "yes". Unfortunately, the perfect, non-committal economist answer holds due to uncertainty of future returns and tax regimes.
Recent research still holds that investors are better off locating bonds and other assets subject to high investment tax in retirement accounts and low-tax investments in taxable accounts2. This generally equates to bonds in retirement accounts and stocks in taxable accounts to the extent available within their targeted asset allocation, with certain exceptions3. Asset location is going to be highly sensitive to the following assumptions:
- Capital gains are taxed less than ordinary income
- Dividends are taxed less than interest
- No tax loss harvesting
- Expected returns on stocks are greater than bonds
o Extremely low bond yields can lead to stocks being located in retirement accounts
- No liquidity need
It is also important to note that the decision to add funds to a Traditional or Roth IRA/401(k) should be driven by the investor's current tax situation and expected future tax rate in retirement. Even though the Roth space is more valuable, since no taxes are paid on monies withdrawn in retirement, this might not justify the upfront cost of ordinary income tax. Stated differently, asset location adjusts to contributions and asset allocation, not the other way around. The dog (asset allocation) wags the tail (asset location).
Linear optimization can be utilized to determine the "best" location of assets. Betterment has an online Asset Location Calculator that explores the two assets scenario in a simple and easy to utilize fashion. If investors are able to "smile"4, they will be able to capture a majority of the tax benefits without having to resort to running complex optimization models (figure 1).
The "smile" chart outlines the main strategy of locating the assets with the most tax-efficiency in taxable accounts and inefficient assets into retirement accounts. However, there is a point where it becomes more advantageous from an after-tax perspective to locate assets with high expected returns and high tax efficiency into tax-exempt accounts (Roth IRA). Asset location is a process that requires monitoring and possible changes based upon changes in tax codes, expected returns, and expected distributions. These also, then, must be weighed against the tax impact of relocation.
Optimal Withdrawal Strategies
Traditional financial advice typically suggests that investors withdraw monies from their taxable accounts first, traditional IRAs second, and Roth IRAs last. However, this is not likely to be the most efficient means of spending down a portfolio. The work of Cook, Meyer, and Reichenstein illustrate that portfolio longevity can be increased by drawing from the three accounts simultaneously to minimize the amount of taxes that are paid, which reduces the amount of money required from the portfolio5. Their study found that portfolio longevity could be extended ~1.22 years by withdrawing assets strategically amongst Taxable, Traditional, and Roth accounts instead of drawing down a portfolio starting with the Taxable account first and the Roth account last. Their study also found that strategically converting monies from Traditional to Roth added ~1.14 years to the tax-efficient withdrawal strategy for a gain of ~2.3 years versus the "sequential" strategy.
Working through a simple example to illustrate tax-efficient withdrawals, we assume our single investor has a portfolio of Taxable, Traditional, and Roth accounts and requires $100,000 after tax for expenses. For simplicity's sake, the taxable account has a cost basis of 75% with all gains long term, and the investor has no income outside of the portfolio and no tax deductions. Table 8 below outlines the scenario where the investor draws down their portfolio sequentially, starting with the Taxable account and ending with the Roth account. In the early years, the investor would pay zero tax, since the $25,000 in taxable gains would put them in the 15% tax bracket, where long-term gains are taxed at 0%. After the taxable account is exhausted, the investor would need to draw ~$129,000 to get $100,000 after tax, placing them in the 28% marginal tax bracket.
Table 9 outlines a slightly more efficient means to withdraw from the portfolio. The "equal distribution" scenario has the investor withdraw monies from the Traditional up to the 15% tax bracket, and then equally on an after tax-basis from the Taxable and Roth. This results in a total withdrawal from the portfolio of ~$111,000 and taxes of ~$11,000.
In comparing the two tables, we see that in the early and later years of drawing down the portfolio, the "equal" strategy pays more in taxes and requires more than $100,000 to be drawn from the portfolio to meet spending needs. The "equal" strategy reduces taxes and the subsequent amount withdrawn from the portfolio in comparison to an investor who only utilizes a Traditional to fund all expenses. This strategy illustrates a possible improvement on tax efficiency for withdrawals in retirement; however, the relative sizes of the three account types will determine the most efficient withdrawal strategy.
The basic premise is to keep withdrawals from the Traditional IRA as well as the Taxable account in lower marginal tax brackets over the retirement period. The period between retirement and required distributions from IRA accounts affords the investor the most flexibility to take advantage of "low" tax years. These "low" tax years could be the result of retiring and being in a substantially lower tax bracket or a large income tax deduction (i.e., healthcare expense, charitable giving).
In these "low" tax years, investors should look to draw funds from the Traditional IRA to either fund living expense or convert to a Roth. It is also likely advantageous to keep monies in the Traditional IRA for later in life, since this is the period most likely to have high medical expenses, which can offset income taxes. The big takeaway is that investors should be mindful of their overall tax situation and monitor it to determine the best source of funds to maximize after-tax monies over the retirement period, not just on a single-year basis.
Optimize Your Portfolio
A study by Synchrony Financial6 (formerly GE Capital) found that the average shopper spent 63 days researching a major purchase. The same study also found that 90% of shoppers compared prices and promotional deals to ensure they got the best price. Although the study does not explicitly state how many days were spent on bargain hunting, we assume it was more than the number of days spent by an average person contemplating their investment portfolio.
Peak Capital urges investors and our clients to at least apply the same amount of vigorous research to their own portfolios as they do in buying a new washer & dryer. Take advantage of the promotional deals offered by the IRS as you would from Crazy Eddie's.
We hope our Investor's Alpha series is helpful to you, the investor, or to advisors in communicating with your clients. Any questions or feedback is always appreciated
Adam Hoffman, CFA, CAIA
 Vanguard Group. (2016, September). "Putting A Value On Your Value: Quantifying Vanguard Advisor's Alpha". Retrieved from Vanguard.com
 Reichenstein, William, CFA, Stephen M Horan, CFA, CIPM, and William W Jennings, CFA. (2015, January / February). "Two Key Concepts For Wealth Management and Beyond". Retrieved from Financial Analyst Journal. Vol 71, No 1.
 Reichenstein, William, CFA and William Meyer. (2013, November). "The Asset Location Decision Revisted". Retrieved from Journal of Financial Planning.
 Betterment. "White Paper: Tax-Coordinated Portfolio". Retrieved from Betterment.com
 Cook, Kristen, William Meyer, and William Reichenstein, CFA. (2015, April/May). "Tax-Efficient Withdrawal Strategies". Financial Analyst Journal. Retrieved from CFAPubs.org
 Synchrony Financial. (2016, December). "Fifth Annual Major Purchase Consumer Study". Retrieved from SynchronyFinancial.com
Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.