Welcome to the third installment of picking up pennies. Last month, we discussed investing fixed income in IRAs and investing equities in ROTH and taxable accounts to minimize taxes and maximize after-tax returns. However, we employ many more tax strategies to reduce the taxes our clients pay each year. This month, we will discuss how Exchange Traded Funds (ETFs) further reduce our clients’ annual taxes.

•   Volume 1 – Keep Cash Balances Low (Better Chance for Higher Returns)
•   Volume 2 – Asset Location (Reduces Taxes)
•   Volume 3 – Using ETFs  (Reduces Taxes)
•   Volume 4 – Trading ETFs in Competition (Reduces Trading Costs)
•   Volume 5 – Number of Funds and Not Auto-Reinvesting Dividends (Reduces Trading Costs)
•   Volume 6 – Tax Lots and Tax Loss Harvesting (Reduces Taxes)
•   Volume 7 – Summary (Total Impact)

What is an ETF?

An ETF is a type of pooled investment vehicle, just like a Mutual Fund. Investors pool their money together and hire an asset manager to invest it toward a common investment goal. ETFs typically invest in publicly traded securities like stocks and bonds. ETFs and Mutual Funds are just “wrappers” for different investment strategies. What do we mean by “wrapper”? You have many choices as you wrap presents for your loved ones this holiday season. You can use wrapping paper, boxes, gift bags, etc. Although these options have different aesthetic appeals and costs, people care about what’s under the wrapping. They care about the gift. The same is true for investments. Investment strategies can be wrapped in an ETF or a mutual fund. You care about how your money is being invested under the wrapping.

Why use ETFs?

Although ETFs and Mutual Funds are very similar, there is one important difference between the two that allows ETFs to provide investors with tax advantages. No matter your investment strategy, you will eventually have to place trades. You will own stock A and want to buy stock B. What mutual fund managers do is sell stock A and then buy stock B. When they sell stock A, they may realize a capital gain. At the end of the year, all of those capital gains from their trades are passed on to the end investors in the mutual fund. Thus, every investor gets a tax bill at the end of the year.

ETFs work differently. An ETF manager can “exchange” one set of stocks for another. So rather than sell stock A and buy B, an ETF manager can go to a market participant and exchange stock A for stock B. Because no cash changes hands, no capital gains are realized. Thus, at the end of the year, no capital gains are passed on to investors. ETFs don’t eliminate the capital gains taxes; they defer them. Thus, you only pay the capital gains when you, the investor, not the manager,  sell the investment. You get to determine when you pay taxes rather than being forced to pay them year after year.

This deferral of taxes provides investors with a lot of advantages. By deferring taxes, you can continue to invest the money you would have paid in taxes and earn a return on it. In addition, if you hold the assets to death, your beneficiaries would get a step-up in cost basis, and you would never pay the taxes. Assuming no step-up, the after-tax return benefit of using ETFs rather than Mutual Funds is ~0.05% per year. Including the step-up at death, the benefit would be ~0.5% per year.

Although these tax savings can be large, trading ETFs can be trickier than trading mutual funds. Next month, we will talk about how we trade ETFs by having market makers compete for our business and lower trading costs for clients. This is yet another way to bring unique value to our clients.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies. Returns and market information quoted here was pulled from publicly-available, third-party sources believed to be accurate. Investments involve risk and, past performance is not indicative of future performance. Any actual return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser before implementing any investment strategy.

If an investor makes a concentrated bet, he thinks he knows something that the market doesn’t. If an investor diversifies, he admits he doesn’t know what comes next. We are the latter, and the data constantly reminds us to be humble. Here is an image showing the developed markets’ ranking and respective returns over the last twenty years. Would we have predicted Denmark as the standout market or Ireland in the last position? And who will it be twenty years from now? Guess what? As you know, when you own global capitalism, you’re the winner, and guessing isn’t required to succeed.

Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Diversification neither assures a profit nor guarantees against loss in a declining market.

Welcome to the second installment of picking up pennies. Last month, we discussed minimizing the cash in our client’s portfolios to maximize the return our clients get from their assets. Improving financial outcomes does not only come from maximizing investment returns, though. It also comes from minimizing taxes. This month, we will discuss asset location, what it is, how one can benefit, and how we use it.

•   Volume 1 – Keep Cash Balances Low (Better Chance for Higher Returns)
•   Volume 2 – Asset Location (Reduces Taxes)
•   Volume 3 – Using ETFs (Reduces Taxes)
•   Volume 4 – Trading ETFs in Competition (Reduces Trading Costs)
•   Volume 5 – Number of Funds and Not Auto-Reinvesting Dividends (Reduces Trading Costs)
•   Volume 6 – Tax Lots and Tax Loss Harvesting (Reduces Taxes)
•   Volume 7 – Summary (Total Impact)

What is asset location?

Asset location is investing different types of assets (stocks vs. bonds) in various types of accounts (IRAs vs Trusts) to reduce overall taxes the investor pays over time.

The typical investor has three different types of accounts that are each taxed differently: IRAs (tax-deferred), Trusts (taxable), and ROTHs (tax-exempt). Since the investment gains from stocks and bonds are taxed differently, it is important to match the assets and accounts in a tax-optimal way.

How can asset location reduce taxes?

Taxable bonds (i.e., non-municipal bonds) are very tax-inefficient assets as they produce annual taxable income taxed at ordinary income rates (higher tax rates) rather than capital gains tax rates. If you hold bonds in a taxable account, you must pay those taxes year after year. Ultimately, this will reduce the dollar amount of investible assets that investors can earn a return on. Therefore, holding bonds in an IRA and deferring those taxes is preferred.

Stocks (particularly ETFs) are tax-efficient assets because most of their growth comes in the form of capital gains (lower tax rates) that you only need to pay when you sell the investment (not every year). If you hold stocks in an IRA, those gains will be taxed at ordinary income tax rates when you take distributions rather than capital gains rates. Thus, having stocks in a taxable account and paying the lower capital gains rate is preferred. Further, because stocks also tend to grow in value faster than bonds, if you have the option of a ROTH account, you would prefer to hold stocks in a ROTH account because you don’t pay any taxes on those gains nor their distribution from the account.

Let’s look at a simple example. Imagine an investor who wants to own 50% in stocks and 50% in bonds. In addition, half of their money is in an IRA, and half is in a taxable trust. Most advisors simply invest each account in the same 50/50 allocation. It is simple and easy to manage. You can buy software that automatically checks and rebalances the portfolio to these percentages.

Unfortunately, the above is not a tax-optimal solution. If we compare a lazy, uniform 50/50 solution to an asset location-optimized portfolio over a 30-year period, we’ll see a substantial difference in outcomes.

Assumes 5% bond returns and 10% equity returns. Assumes a 25% income tax rate and a 15% capital gains tax rate.

With the same starting capital ($1M) and the same 50/50 overall allocation, an investor ends up with 6.2% more wealth over a 30-year investment period by using asset location effectively. This equates to 0.2% higher returns every year. This benefit will change for each investor based on their allocation and money in each type of account. The higher your tax rate, the more critical the optimal location becomes.

How does HIG use asset location?

We manage the allocation for all our clients at the household (highest) level rather than the account (lowest) level. By looking at the entire household, we can take advantage of asset location by putting assets like bonds and real estate in IRAs and high-growth assets like stocks in taxable and ROTH accounts. This way, we can ensure that each client has the correct allocation at the household level while being flexible at the account level to take advantage of the tax advantages of asset location.

We do this by creating a priority list for each type of account. We will put as many stocks as possible in a Roth, as much real estate and bonds as possible in the IRAs, and the overflow will be invested in the taxable accounts. Overall, investors don’t benefit from total investment returns; they care most about after-tax returns. Although care for asset location takes more time to manage, our commitment to picking up every basis point is part of a broader philosophy and commitment at Hill Investment Group. We understand that the little things, the pennies, add up to create meaningful gains for our clients. Through careful management and a relentless pursuit of opportunities, we believe these small gains will culminate in a substantial increase in overall returns. 

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies. Returns and market information quoted here was pulled from publicly-available, third-party sources believed to be accurate. Investments involve risk and, past performance is not indicative of future performance. Any actual return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser before implementing any investment strategy.