Tax-Efficient Investing: Why it Shouldnt be Ignored & How Asset Location Can Help

There are two kinds of investors in this world: Those who maximize investment returns and those who do not understand the tax code.

Investors don’t always realize it, but Uncle Sams taxes can significantly erode the return on investments over time. This is becoming more and more of a concern as the 2010 Bush tax cuts come to an end, leaving us in a relatively uncertain tax environment.

Luckily for you, portfolio taxes are one of the few investment factors investors can effectively manage. By taking advantage of the tax code. you can minimize tax erosion and maximize the overall return of your investment portfolio .

This article will answer two very important questions: What is the affect of taxes on my investment portfolio? and How do I make my investment portfolio more tax-efficient?

What is the Affect of Taxes on My Investment Portfolio?

The impact of taxes on an investment portfolio is sometimes referred to as the portfolio’s “tax drag .  The chart below illustrates the hypothetical growth of a $2 portfolio with $1 invested in stocks and $1 invested in bonds, before and after taxes, from 1926-2010. The total portfolio has a compounded annual growth rate of 9.95% before taxes and 7.88% after taxes. This means that the portfolio loses 2.07% of growth to taxes on a compounded annual basis.

The above 2% compounded annual growth rate differential may not seem like much, but take a look at it in terms of dollars:

The tax drag on our hypothetical investment portfolio’s 85-year return is a whopping $2,532.  Roughly 80% of the portfolio’s returns went to taxes! Case in point, taxes can kill your portfolio’s long-term investment return.

( Side note: Yahoo! Finance has a useful calculator if you are interested in estimating the impact of taxesand inflation on your investment return : → How do taxes and inflation impact my investment return? )

How Do I Make My Investment Portfolio More Tax-Efficient?

The first step to minimizing the tax drag on your investment portfolio is to familiarize yourself with “Asset Location .  Asset Location is a portfolio management strategy that takes advantage of the various tax treatments associated with different types of investments. When used correctly, this strategy “locates, or places, tax-efficient investments in taxable accounts and tax-inefficient investments in either pre-tax (401ks, 403bs, Traditional IRAs) or post-tax accounts (Roth IRA, Roth 401ks).

While Asset Location is simple in theory, many investors fail to properly implement it. To simplify the implementation process, below I have listed a general three step approach to Asset Location and a scale of investments approximately arranged by their tax-efficiency.

Basic Asset Location: 3 Step Approach

Please note: this list and the subsequent illustration describes Asset Location in its simplest form and is included for informational purposes only. You should consult with a qualified financial advisor before making any changes to your investment profile. You should not assume that any discussion or information contained in the presented material(s) serves as the receipt of, or as a substitute for, personalized investment advice from PWM. See the detailed disclaimer at the end of this article for more information.

1) Locate your most tax-inefficient investments in your pre-tax accounts (401ks, 403bs, Traditional IRAs).

2) After you have maxed out your pre-tax account, locate the rest of your “most tax-inefficient” investments in your post-tax accounts (Roth IRAs, Roth 401ks).

3) Try to only locate tax-efficient investments in taxable accounts ( one caveat:  Do not miss out on an intelligent investment just because it is tax-inefficient and can only fit in one of your taxable accounts.)

Investment Tax-Efficiency Scale

The scale below approximately lists investments by tax-efficiency. with the least tax-efficient on the top and most tax-efficient on the bottom.

Tax-Efficient Investing is Important

Taxes can significantly hinder your investment returns. If you are not taking full advantage of your taxable and tax deferred accounts you could be leaving a lot of money on the table.

Compare your next investment statement with the chart above to get a general idea of your portfolio’s tax efficiency. If you have any questions or concerns, please do not hesitate to contact a PWM Financial Advisor. [→Contact PWM]