Benjamin Franklin’s old line about death and taxes rings as true today as it did more than 200 years ago. Taxes are such a normal part of life that people may overlook them until it’s time to file their returns. Unfortunately, by that point it’s usually too late to implement a strategy for minimizing their tax bill.
Returns lost to taxes
When it comes to investing, it's not just how much you make that matters—it’s how much you keep after taxes.
The Schwab Center for Financial Research examined the long-term impact of taxes and other expenses on investment returns and concluded that while investment selection and asset allocation are still the most important factors affecting your returns, minimizing taxes and other costs isn't very far behind.
The good news is you can exercise a good deal of control here. With a bit of planning, you can maximize the tax efficiency of your portfolio and help reduce the effect of taxes on your investments.
Think of it this way: You can exercise far more control over your portfolio’s tax situation than you can over its exposure to the short-term gyrations in the market.
How do I maximize tax efficiency?
Investment accounts can be divided into two main categories, taxable accounts (like a brokerage account) and tax-advantaged accounts (such as an IRA, 401(k), or Roth IRA). As a general rule, investments that tend to lose less of their return to taxes are good candidates for taxable accounts. Likewise, investments that lose more of their return to taxes may be better suited for tax-advantaged accounts. Here’s where you might consider placing your investments:
Of course, this presumes that you hold investments in both types of accounts. If all your investment money is in your 401(k) or IRA, then just focus on asset allocation and investment selection.
Diversifying by tax treatment
Holding your investments in different accounts based on tax treatment (i.e. taxable and tax-advantaged accounts) adds value during the accumulation phase of your financial life by allowing you to defer taxes (or, in the case of a Roth, eliminate entirely the taxes on investment returns1). It also adds an additional layer of diversification to your portfolio during the distribution phase in retirement. Call it “tax diversification.”
Diversifying by tax treatment can be especially important if you’re uncertain about the tax bracket you’ll end up in down the road. For example, if you’re on the fence, instead of choosing between a traditional IRA or 401(k) and a Roth account, why not split your contributions between the two? When you start withdrawing money in retirement, you’ll be able to manage your income tax bracket with more flexibility because you’ll be able to choose which accounts you take your cash from based on the tax implications.
For example, to minimize your tax burden, you could focus on taking tax-free municipal bond income, qualified dividends and long-term capital gains from your taxable accounts and tax-free income from your Roth accounts. That would free you up to take only enough money from your taxable IRAs to keep you from moving into the next highest tax bracket (or to satisfy required minimum distributions, if applicable).
Making strategic use of your different accounts according to their tax treatment can also help you plan your charitable giving and estate planning goals—different accounts receive different types of gift and estate tax treatment. For example, you might want to give appreciated securities from your taxable accounts to charity for a full fair market value deduction and no capital gain tax. You can also leave such shares to your heirs who will receive a step-up in cost basis after you’re gone. Roth IRAs also make a great bequest, as distributions are free from income tax for your beneficiaries.
However you decide to split up your portfolio between account types, remember that for asset allocation purposes, you should still think of all your investments as being part of a single portfolio. By way of an oversimplified illustration, if you kept all your stocks in your taxable account and an equal amount of money in bonds in your tax-advantaged account, you wouldn’t have two portfolios consisting of 100% stocks and 100% bonds. You would have one portfolio consisting of 50% stocks and 50% bonds. The different assets just happen to be in different accounts.
In general, holding tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged accounts should add value over time. However, there are other factors to consider, including:
- Periodically rebalancing your portfolio to maintain your target asset allocation. Because rebalancing involves selling and buying assets that have either grown beyond or fallen below your original allocation—essentially, you take profits from your winners and buy assets that have underperformed—it could cause an additional tax drag on returns in your taxable accounts. In taking profits from assets that have grown, you may incur either long- or short-term capital gains. You may want to focus your rebalancing efforts on your tax-advantaged accounts and include your taxable accounts only when necessary. Adding new money to underweighted asset classes is also a tax-efficient way to help keep your portfolio allocation in balance.
- Active trading by individuals or by mutual funds, when successful, tends to be less tax-efficient and better suited for tax-advantaged accounts. A caveat: Realized losses in your tax-advantaged accounts can't be used to offset realized gains on your tax return.
- A preference for liquidity might prompt you to hold bonds in taxable accounts, even if it makes more sense from a tax perspective to hold them in tax-advantaged accounts. In other situations, it may be impractical to implement all of your portfolio's fixed income allocation using taxable bonds in tax-advantaged accounts. If so, compare the after-tax return on taxable bonds to the tax-exempt return on municipal bonds to see which makes the most sense on an after-tax basis.
- Estate planning issues and philanthropic intent might play a role in your portfolio planning. If you're thinking about leaving stocks to your heirs, stocks in taxable accounts are generally preferable. That's because the cost basis is calculated based on the market value of the stocks at the time of death (rather than at the time they were originally acquired, when they may have been worth substantially less). In contrast, stocks in tax-deferred accounts don't receive this treatment, since distributions are taxed as ordinary income anyway. Additionally, highly appreciated stocks held in taxable accounts for more than a year might be well-suited for charitable giving because you'll get a bigger deduction. The charity also gets a bigger donation, than if you liquidate the stock and pay long-term capital gains tax before donating the proceeds.
- The Roth IRA might be an exception to the general rules of thumb discussed above. Because qualified distributions are tax free, assets you believe will have the greatest potential for higher return are best placed inside a Roth IRA, when possible.
The bottom line
If you want to keep more of your income, managing your investments with tax efficiency in mind is a must. What’s more, tax efficient investing techniques are accessible to almost everyone—it just takes some planning to reap the benefits. If you have a tax or financial advisor, be sure to talk with them about tax efficient strategies that could be implemented within your investment portfolios or call a Schwab Financial Consultant to learn more.
1 If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties.
What you can do next
- Make sure that you’re considering the potential tax implications of your investments. Learn more about investment advice at Schwab.
- Talk to a financial professional. Find a Schwab Financial Consultant or visit a branch near you.
- If your tax situation is complicated, you may want to consult a tax professional.