Building a Tax-Efficient Portfolio
Bowen Financial Services, LLC focuses on tax efficiency. Taxes are the single largest expense on investments, and they are the expense over which you have the most control. In fact, research published by Vanguard in 2018 states having a tax efficient portfolio can increase after-tax returns by as much as 0.42% annually. Our in-depth tax knowledge of various combinations of investment types and accounts allows us to build client portfolios that are extremely tax efficient lowering taxes paid both pre- and post-retirement. This blog post is more technical but will discuss some factors we consider to reduce the taxes our clients pay on investments.
What we must first understand is how the money in different accounts is taxed. This is important because when determining how a portfolio is taxed, typically the tax treatment of the account overrules the tax treatment of any investment inside the account. Generally, investment accounts fall into three categories: Brokerage, Traditional Retirement, and ROTH accounts.
Brokerage accounts are your standard investment account. You fund a brokerage account with money on which you have already been taxed. Another way to look at it is that it is funded with the same money that would otherwise be in your checking or savings account. Income generated from investments in a brokerage account is taxed when it is recognized and included in that year’s tax return. The tax treatment of this income depends on the type of investments held.
Traditional retirement accounts include accounts like a deductible IRA or 401k. These accounts are funded with pre-tax (commonly referred to as tax deferred) money. Income generated from investments in a retirement account is not taxed until it is withdrawn from the account. Tax on withdrawal treats every dollar the same regardless of the type of income earned from investments. Every dollar withdrawn from a traditional retirement account is taxed at your marginal tax rate for the year of withdrawal.
ROTH accounts are a popular subsect of traditional retirement accounts. The primary difference between Roth and traditional retirement accounts is that Roth accounts are funded with money on which you have already been taxed similar to a brokerage account. In exchange for not receiving beneficial tax treatment on your contributions, income generated from investments in a ROTH account is not taxed when withdrawn assuming certain requirements are met.
That covers the more common account types. What we must understand next is how income from different types of investments is taxed. To be succinct we will be breaking down the most common forms of income generated from investments: short-term and long-term capital gains, qualified and nonqualified dividends, and interest.
Capital gains refer to the amount your investment has appreciated from the time you purchased it to the time you disposed of it. If you own the investment for a year or less, then the capital gain is short-term and taxed at your marginal tax rate. If you hold the investment for more than one year, then the capital gain is considered long-term and taxed at the preferential long-term capital gain rates. If you are invested in a mutual fund or ETF that generates capital gains, those capital gains are generally reinvested into the fund with the recognition of said gains split out proportionally among the owners of the fund.
When investing in stocks, or mutual funds and ETFs with underlying investments in stocks, you may receive dividend distributions. Dividends can be either qualified or nonqualified. Qualified dividends are far more common and are taxed at the same preferential rate as long-term capital gains. Nonqualified dividends are taxed the same as short-term capital gains. Investments that produce nonqualified dividends include certain foreign companies, distributions from certain US entities such as real estate investment trusts (REITs), dividends received on money market funds, and dividends on stocks that have not been held long enough to qualify.
When dividends (either qualified or nonqualified) are received from foreign investments, you owe tax on these dividends to the country of origin. To keep reporting simplified, most foreign dividends have these taxes automatically withheld. Tax withheld on foreign dividends means you pay foreign taxes regardless of which type of account houses the investment. If these foreign taxes are withheld on taxable investments (investments held in a brokerage account) then the investor receives foreign tax credits to offset their federal tax liability.
When investing in bonds or other forms of fixed income, you receive interest on those investments. Interest is taxed at your marginal tax rate like nonqualified distributions or short-term capital gains. There are exceptions when invested in municipal bonds or other fixed income investments explicitly mentioned by the internal revenue code to have a different tax structure.
Now that we have a general overview of the taxability of common investment accounts and common forms of investment income you can start asking the question: Which investments should be housed inside which account to minimize the tax liability of my portfolio? In a perfect world you would want investments with favorable tax treatments in a brokerage account, investments without favorable tax treatment inside a traditional retirement account, and investments with the greatest potential appreciation inside a Roth account. However, everyone’s situation is unique which may prevent them from having a 100% tax optimized portfolio. Additionally, taking an existing portfolio and making it tax efficient should not be done without first planning ahead as trades and transfers undertaken to increase tax efficiency are usually taxable events themselves.
Written May 26th, 2022
By John W Bowen
As always, please consult a tax professional to analyze your personal situation. The opinions expressed and information provided in this blog are intended to be general education and should be considered neither investment advice nor solicitation for services or purchase or sale of any security. Information contained herein is subject to change and is considered accurate as of the date of publication. Bowen Financial Services, LLC is under no obligation to update this post to reflect future changes.