Nowadays, it is common that individuals have multiple investment accounts, such as an IRA, 401(k), Roth IRA and a taxable individual brokerage account. What is the best way to manage these multiple “money pools”? Do you treat each account as its own portfolio? Alternatively, do you look at all of the accounts as a whole, where some funds are held in one account but not others? Treating each account as its own portfolio can be easier to establish and maintain. However, a “whole of accounts” portfolio methodology can actually provide a better opportunity to strategically allocate funds between taxable and tax-advantaged accounts, which can result in a superior tax efficiency and, ultimately, better overall return on investment. If a larger portfolio is the goal, a little bit of extra effort might be worth it, correct?!
So, the whole of accounts approach sounds great but how does it work in practice? First, the strategy is most applicable when you have a mix of taxable and tax-advantaged accounts. Taxable accounts are those where you pay tax annually on any income earned within the account. Tax-advantaged accounts enjoy preferential treatment in the tax code typically to encourage retirement savings, and there are two primary types of tax-advantaged accounts. Tax-deferred accounts are the most familiar types of tax-advantaged retirement accounts where “pre-tax” funds are contributed into the account and the tax is subsequently paid during retirement when funds are withdrawn. The kicker is that you will pay ordinary income tax rates (think the tax brackets that you pay on your earned income) on all withdrawals from a tax-deferred account. The other kind of tax-advantaged account is tax-exempt. In these accounts, you pay tax at the time you make your contribution, but all future earnings are free of tax as long as you follow the rules. A tax-deferred account is best utilized when you expect to pay a lower tax rate in retirement, while a tax-exempt account is most appropriate when your expected retirement tax rate will be equal to or less than your current marginal tax rate. Typical accounts that fall within these categories are:
In general, funds that pay ordinary dividends (such as bond funds) and significant dividend payments should be held in tax-advantaged accounts, such as a 401(k). Funds that have low portfolio turnover and low dividend payouts should be held in taxable accounts. The reasoning comes back to tax rates. Ordinary dividends are taxed at ordinary income tax rates, while qualified dividends and capital gains from selling the investments are taxed at typically lower capital gains tax rates. Think about it like this – bonds and bond funds pay out ordinary dividends throughout the life of the bonds. Since all withdrawals from a tax-deferred account will be taxed at ordinary tax rates, wouldn’t it be best to keep the ordinary income in those accounts, rather than paying the typically higher ordinary income tax on payouts that occur in a taxable account?
The strategy can be further refined and optimized by keeping higher growth funds in tax-exempt accounts, while slower growing funds are held in tax-deferred accounts. Ideally, it would be great to have most of your assets in a tax-exempt account, when you enter retirement, correct?! The downside with this strategy is that higher growth usually means the tax-exempt account will typically hold more equity securities and will be more volatile than the tax-deferred account. Keep in mind, however, that these accounts are intended to provide retirement funding and are meant to be long-term investments, where short-term volatility should not be a concern. Additionally, the whole of accounts approach is meant to control volatility over the entire portfolio and does not focus on volatility of each individual account.
Let’s look at an example.
Suppose your $500,000 portfolio consists of the following accounts:
And these funds are held in the portfolio:
A tax-efficient allocation between these accounts might look like:
Of course, the individual funds utilized in the portfolio should be examined for their individual tax efficiency, which might result in an allocation different than presented in the example above. The allocation should also consider potential foreign tax credits for international investments. Because international funds must pay foreign taxes regardless of the account they are held in, it might make sense for some, or all, of these assets to be placed in the taxable individual brokerage account, depending upon their overall tax-efficiency.
Another consideration in the allocation strategy is the utilization of tax-advantaged bonds, such as municipals. If municipal bonds are utilized in the overall portfolio, it does not make sense to put these assets in a tax-advantaged account. If bonds are utilized in a tax-advantaged account, higher-yielding taxable bonds would typically provide the better option considering none of the earnings in the account are currently taxable.
So, how do you execute the strategy while contributing to or withdrawing from the portfolio? Implementation can be a bit tricky. For instance, let’s say you hold all of your fixed income investments in your IRA and you are looking to add funds to your taxable individual brokerage account. You’ve determined that your overall portfolio is currently underweight in fixed income so you would like to purchase a fixed income fund with the new investment. The tax optimization strategy calls for purchasing the fixed income fund in the IRA, but the available cash is currently residing in the taxable account. In order to free up cash in the IRA and make the desired purchase, you can simultaneously sell equity securities in the IRA and buy the same security with the cash in the taxable account. This simultaneous buy-sell transaction will then free up cash in the IRA which can be utilized to purchase the fixed income investment.
To further clarify implementation, let’s take the portfolio we developed above and add $5,000 cash to the Individual Brokerage Account. With the addition of the $5,000, our portfolio now looks like:
We’ve determined that we want the $5,000 to be invested in the US Aggregated Bond Fund and that this fund is best held in the 401(k) account. Therefore, we want to free up some cash in the 401(k) by:
Selling $5,000 International Equity Fund in the 401(k); and
Buying $5,000 International Equity Fund in the Individual Brokerage Account
The cash generated by the sale in the 401(k) can then be utilized to purchase the US Aggregate Bond Fund and the resulting portfolio will look like:
Although this tax optimization strategy can help improve overall portfolio performance over time, it is important to review each individual’s circumstances. The strategy may not be applicable and may actually produce negative results for some individuals. As with all investment strategies, you should consult with your financial advisor and implement a plan appropriate for and tailored to your individual circumstance.