Important Note: Nothing in this article should be construed as tax advice as I am not a tax expert. This is simply my opinion based on my own experience and study. It is probably prudent to check any and all tax implications with a professional tax advisor before making any financial decisions based off of the content in this article.
Benjamin Franklin once wrote:
In this world, nothing is certain except death and taxes."
While we cannot help you get around the problem of physical death, in this article we will endeavor to help you construct a portfolio which - once you put your money in - will never be taxed again: Not at the corporate level and not at the individual level either. As a result, your money should be able to compound at an even higher rate of return over the long term and your passive income stream will not have to take a hit from the increasingly hungry tax man. All you need to build this portfolio is the ability to invest in a regular taxable brokerage account as well as a Roth IRA and/or Roth 401k brokerage account.
In this article we discuss how investors can build a tax free portfolio and why now is a great time to do so. We also share some of our top picks for building this portfolio.
The constituents of the tax-free portfolio are quite simple.
In your Roth accounts invest in a combination of:
Then, in your taxable account, invest in a combination of:
The main pro of this approach is provided in the name of the portfolio: It is tax-free.
In your Roth accounts, all you need to do is select investments that do not pay corporate income tax. The rate at which your own dividends and capital gains from these investments are taxed does not matter because they're sheltered from taxation in the Roth account. As a result, corporate income tax-free pass-through entities like REITs and BDCs are ideal for Roths. Furthermore, bonds and precious metals typically have disadvantageous tax rates on capital gains and interest income outside of Roths, but inside them they are immune to these taxes. Furthermore, since gold is a natural resource rather than a productive enterprise, and bonds are simply a contractual obligation between the borrower and the lender, neither are subject to corporate income tax.
Given that you can invest at least up to $22,500 per year into a Roth 401k and at least up to $6,500 into a Roth IRA in 2023, and these limits increase just about every year (especially as you get closer to retirement age due to catch-up provisions), there's no reason why these accounts alone would not be sufficient to build a satisfactory nest egg. Saving $29,000 per year from age 25 to 65 at an 8% annualized rate of return turns into a whopping $8.1 million by retirement. Even doing so from age 35 to 65 generates over $3.5 million.
That said, for those ambitious savers out there, you can still invest tax free outside of tax-sheltered accounts by investing in instruments like tax-exempt bonds (whose interest you do not need to pay taxes on) as well as MLPs.
MLPs are pass-through entities, so they're not subject to corporate income tax and pass on their cash flows to unitholders. However, the depreciation write-offs are so significant that the cash distributions are pretty much entirely classified as return of capital. As a result, the tax due is deferred until sale and the cost basis of the investment is simply reduced accordingly.
If you simply buy and hold the MLPs until you die, with occasional reinvestment of distributions to restore some of your tax basis so it never hits zero, you will rarely if ever have to pay any taxes on this investment. Then, you can pass the MLP units on to your heirs with a step-up in cost basis to whatever the market value is at the time of transfer. With that, you will have generated potentially decades of income on a truly tax-free basis without burning up your allocations to your Roth accounts.
The beauty of tax-free investing is that your wealth will compound much more efficiently. Every dollar in pre-tax profit that your investments generate will be yours, not the government's.
In your Roth account, your precious metals capital gains will be fully yours, as will the interest from your bonds. Meanwhile, your REITs and BDCs will pay you hefty dividend yields that you will never own a penny of interest on. Moreover, the cash flow that they retain will be fully reinvested into growing the business rather than having to go to paying taxes. Additionally, future returns on that cash flow will be tax free for both them and you, further accelerating the compounding process.
In your taxable account, the same principles apply because your interest from your tax-exempt bonds will fully flow through to your bottom line instead of the tax-man grabbing his share. Meanwhile, your MLPs will behave virtually identically to the REITs and BDCs in your Roth accounts since their distributions are almost always tax-deferred due to depreciation and can eventually become tax-free if you hold them until you pass them on to your heirs.
This approach also is appealing because it gives you exposure to a surprisingly broad and balanced slice of the economy, with:
As a result, between all of these investments, you get remarkable "all-weather" type protection for your portfolio. In fact, when looking at its performance in 2022 the average overall performance looks quite stable:
This performance looks even better when comparing it to the performance of typical portfolio constituents such as the S&P 500 (SPY), Nasdaq (QQQ), high-growth tech (ARKK), and bonds (BND):
As a result, you can invest in a tax-free manner while still maintaining pretty good portfolio diversification.
While we like the tax-free portfolio structure and think it can be a pretty effective way to invest, one important item to keep in mind is proper portfolio diversification.
If you're earlier in your life and are still earning and saving money, you can probably err on the side of growth. In such a circumstance, investing in the higher returning categories of this portfolio (i.e., the REITs, the BDCs, and the MLPs) is probably a prudent thing to do, whereas when you get closer to retirement you may choose to trim your exposure to these riskier elements and instead overweight the bonds and gold element of the portfolio. Perhaps you may even want to invest in a conservative longer-term bond fund with some of your REITs and BDCs, especially if you can get an attractive risk-adjusted yield on that fund relative to your REITs and BDCs.
Alternatively, you may not concern yourself too much with portfolio volatility even as you approach retirement because with instruments like REITs, BDCs, and MLPs, chances are you are going to be generating a very lucrative passive income stream and may never need to touch your principal at all and can simply live off of passive income.
The other item to keep in mind is that as macroeconomic conditions fluctuate, some of these securities can be quite volatile. BDCs, REITs, and MLPs in particular can all fluctuate quite wildly on the public markets, even if their underlying cash flows are generally quite stable. Gold also can go through lengthy periods of underperformance and bonds will generally generate returns that are considerably weaker than equity over the long term. As a result, investors need to keep these issues in mind when building a tax-free portfolio and maintain a long-term mindset.
While shifting allocations some in order to best position the portfolio to perform in current macro conditions is certainly warranted, weighting any single portion of the portfolio too heavily in an effort to time the market exceptionally well adds more risk than the potential reward will likely afford over the long term. If you're not psychologically suited for periods of high volatility in the value of your individual holdings and/or lack the discipline to maintain adequate diversification with a long-term mindset, this portfolio is likely not for you. In such cases, investing in SPY is probably a much better path instead.
While you can simply invest in the aforementioned ETFs to keep things simple, another approach that can further improve returns (due to expense ratios on the funds) - especially if you have considerable investing skill and time to commit to the task - is to invest in individual securities. Some of our favorite picks in the REIT, BDC, and MLP sectors right now include:
Each of these businesses have investment grade balance sheets and well-diversified portfolios that are well positioned to deliver the kind of income and long-term risk-adjusted returns that the tax-free portfolio targets.
While not for everyone, tax-free investing can be a great way to compound wealth over the long-term while minimizing the role of the tax man in siphoning off considerable amounts of your nest egg over time.
We believe that now is a particularly good time to invest in tax-free investments because taxes are expected to increase in the future, so sheltering your hard-earned savings from future tax increases will pay significant dividends down the road. Furthermore, given that interest rates have risen substantially and the economic outlook is weak, bonds, REITs, and BDCs are all on sale while gold and MLPs remain significantly undervalued, in our view.
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This article was written by
Disclosure: I/we have a beneficial long position in the shares of WPC, ARCC, BXSL, EPD, ET, GLD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.