Creating tax-efficient portfolio plans


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A diversified blend of stocks, bonds and cash in your individual retirement account is the proven path to attaining your long-term financial goals. Right?

Well, yes, but you might want to consider a more tax-efficient approach to investing.

While financial experts agree that a mix of securities can help stabilize your overall portfolio, they also note that long-term savers with both taxable and tax-favored accounts may be better served using their IRA primarily to shelter income-producing investments.

Their brokerage accounts, then, can be used for investments with lesser tax implications to maintain their ideal allocation.

Thus, a 40-something retirement saver could still maintain a mix of, say, 60 percent stocks and 40 percent bonds. But the investments held in his various accounts would not mirror one another, says Certified Financial Planner professional Brett Horowitz, a wealth manager and vice president with Evensky & Katz in Coral Gables, Fla.

“We can’t control the market or how it performs, but we do have control over taxes and expenses,” says Horowitz. “To the extent that we can keep inefficient vehicles in our IRAs, and reduce expenses by not holding the same securities in multiple accounts, you can potentially boost your return by up to a half a percent per year.”

That may not sound like much, but over time it can make a big difference in your net worth.

Indeed, an integrated approach that favors tax efficiency may result in higher returns by minimizing your taxable income and eliminating redundant transaction fees.

“It saves clients a lot in commissions because typically each investment is only placed in one account, so if we sell that fund, we only need to sell it once,” says Horowitz. “If the same fund were held in four accounts, you would have to multiply the commissions by four. Every penny adds up.”

Determining your asset allocation

To implement a tax-efficient strategy for your long-term retirement accounts, start by determining your optimal asset allocation, which differs for everyone depending upon his or her financial profile, age and appetite for risk, says Mike Piper, a certified public accountant and blogger at

A moderate investor 10 years from retirement, for example, might opt for 61 percent equities, 31 percent bonds, 6 percent alternatives (such as commodities and real estate investment trusts), and 2 percent cash (money market funds, certificates of deposit), says Horowitz.

That investor’s more conservative counterpart might invert his exposure to equities and bonds, while a more aggressive investor might put up to 90 percent in stocks.

Regardless of where you fall on the risk tolerance spectrum, your equity weighting should include roughly two-thirds domestic stocks and one-third international stocks, says Horowitz, who favors value and small-capitalization mutual funds in the current market environment for their upside potential.

Next, says Piper, determine which specific stocks, bonds and funds best meet your portfolio needs and list them in order from least to most tax-efficient.

“Put your least tax-efficient investments into your IRA and 401(k) first,” he says.

What belongs in your IRA?

Your IRA should include high turnover, actively managed mutual funds and exchange-traded funds that are likely to distribute gains at the end of the year, says Horowitz.

Eventually, you’ll pay ordinary income rates when you start taking distributions from your traditional IRA, but the benefit of compounded growth far outweighs the loss of the lower capital gains rate, which is reserved for investments in taxable accounts, he says.

Plus, you’ll likely be in a lower marginal tax bracket during retirement.

By comparison, earnings on investments held for more than one year in your brokerage account are taxed at the long-term capital gains rate, which was raised from 15 percent to 20 percent in 2013 for the wealthiest taxpayers as part of the American Taxpayer Relief Act.

Other good candidates for your IRA include high-yield bonds and bond funds, along with Treasuries and Treasury inflation-protected securities, or TIPS, which are all taxed as ordinary income, says Horowitz.

The same is true for real estate investment trusts, or REITs, which are required to distribute 90 percent of their income annually to shareholders in the form of dividends.

The benefit of keeping your least tax-efficient investments in your IRA may be amplified if you own a Roth, which is funded with after-tax dollars and therefore grows tax-free, says Larry Luxenberg, a portfolio manager with Lexington Avenue Capital Management in New City, N.Y.

If you don’t anticipate needing the money for many years, he says, investors “in general should consider placing their fastest-growing and riskiest assets inside of a Roth.”

The downside of placing riskier stocks inside a traditional or Roth IRA, however, is that investors would not be able to harvest losses if they underperform. Stock losses inside a taxable brokerage account can be used to offset capital gains.

What belongs in the taxable account?

Conversely, investments that do not produce a high dividend or yield, such as total market index funds and tax-managed stock funds, are best left to your brokerage account, says Piper.

Low-yielding bonds and, more specifically, municipal bonds, which are exempt from federal and often state and local taxes, also make sense for your brokerage account, says Horowitz.

Lastly, you may wish to consider parking your international stock funds in a taxable account as well, as it may be possible to get a tax credit for the foreign taxes you pay from such funds, says Luxenberg. That opportunity is lost in tax-deferred accounts, but the faster anticipated growth (and resulting capital gains) of foreign investments may outweigh that benefit over a long holding period, he adds.

Keep it simple

When it comes to structuring your retirement portfolio for tax efficiency, the name of the game is simplicity, says Ed Slott, an IRA distribution expert and author of several books about retirement, including “The Retirement Savings Time Bomb and How to Defuse It.”

Those with multiple IRAs and 401(k)s from past employers should roll their accounts into a single, traditional IRA, if they wish to defer taxes, or a Roth, if they prefer to pay taxes upfront and benefit from tax-free growth, Slott says. Either way, the fewer accounts the better.

“Older people, in particular, tend to build an inventory of IRAs because years ago they were told that more accounts meant you were more diversified,” he says. “There was some truth to that before banks were deregulated because institutions couldn’t sell one another’s products, but now they can.”

Duplicate accounts, Slott says, make it hard to determine the degree to which your investments overlap. It’s also harder to calculate your annual tax obligation on the earnings. Keeping your accounts to a minimum will help you monitor performance and reallocate as market performance ebbs and flows.

“IRAs do not exist in a vacuum,” says Slott. “You have to look at your whole portfolio, including what’s inside and outside your IRA. If you have all risky stocks in your IRA, you can hedge that with more conservative investments outside your IRA.”

Don’t be alarmed, though, when your investment accounts no longer perform in lockstep.

Retirement savers who allocate assets based on tax implication often get nervous when one part of their portfolio performs worse than others, says Horowitz.

“I’ll get a call from a husband asking why his account performed so poorly when his wife’s did so well,” says Horowitz. “The reason is that we’re trying to maximize the performance of the entire portfolio, not a single account. You can match them up so they all perform the same, but that’s the lazy way out. You’ll lose the overall efficiency by doing that.”