Investing in and of itself can be a complicated endeavor. There are issues that you’ll need to address — what to invest in, what types of accounts are available to you and how much to invest in various types of vehicles such as stocks, bonds and cash. These decisions are all important parts of setting your investment strategy.
One of the crucial components of a solid investing plan is taking the tax ramifications of your strategy into account.
Certainly, we are not advocating that you let tax considerations dictate how you invest. In fact, we feel this is a bad strategy. As the saying goes, “Don’t let the tax tail wag the investment dog.”
Nonetheless, taxes are an important consideration for all investors, and there are some things you can do to coordinate your portfolio and your investing strategy to minimize taxes while not detracting from your investment performance. But if this all seems complicated, don’t worry. We’ll show you that our favorite financial-tech platforms offer simple, foolproof ways to manage these sorts of strategies.
What Is Asset Location?
When it comes to maximizing your after-tax returns without loading up on risk, asset location is the name of the game.
Here’s how it works. There are three different types of saving and investing accounts:
- Tax-deferred — such as traditional IRAs and 401(k)s
- Tax-exempt — such as Roth IRAs and 401(k)s
Asset location is all about determining which investments fit on a tax-efficient basis into which type of accounts.
For example, if you own fixed-income investments such as bonds and bond funds, it would make sense to hold them in tax-deferred accounts such as traditional 401(k)s and IRAs. That’s because the IRS taxes annually the dividends that these investments pay out… and at a higher rate than long-term holdings. So it be preferable to keep these in a tax-deferred account.
When it comes to a Roth account, you’re better off putting in investments that are taxed most often and heaviest. That’s because, if you follow the rules to the letter, your withdrawals from your Roth accounts can be tax-exempt.
Now, for long-term positions in stocks and stock-based investments (such as stock mutual funds and ETFs), taxable accounts make sense if your IRA and 401(k) accounts are full. The capital gains from these types of investments are taxed only when you make a withdrawal — which could be decades in the future — and are generally taxed at a low rate. So a taxable account could be sufficient.
All of this is well and good, but you can see how the asset location strategy can quickly become complicated.
And as we’ve all been realizing in recent years, sometimes these complicated financial matters are best left to automation.
A Robo Advisor With a Solution
Robo advisors have been shaking up the financial-tech (fintech) landscape, demonstrating that sometimes automated investing can be more effective and certainly less costly than using a traditional human advisor.
Here at Investor Junkie, we’ve reviewed many of these companies. One of our favorite robo investing platforms is Betterment.
In 2016, Betterment rolled out what it calls the Tax-Coordinated Portfolio (TCP), an automated asset location manager. The company estimates that its TCP service can save you anywhere from 0.10% to 0.82% in additional after-tax returns. One scenario by Betterment showed the benefit of an extra 0.48% annualized over 30 years. Assuming a compounding annual return of 7.48% (versus 7.00%) and a $100,000 portfolio, the account would grow by $770,622 after 30 years, versus $661,226 without TCP. That’s a difference of $109,396, or 16.5%.
Another Strategy: Tax-Loss Harvesting
Of course asset location isn’t the only strategy that can help minimize your retirement savings’ tax burden. Another method that is also commonly offered by robo advisors is tax-loss harvesting.
This is a process whereby you go through the taxable portion of your portfolio and sell off positions that are worth less than you paid for them. Note we don’t advocate doing this on a blanket basis, but rather based on an analysis of the future prospects of the holding. A good question to ask yourself is, “Would I buy this investment today?”
Generally, investment losses can be used to offset realized gains on other investments when filing your taxes. To the extent that your losses exceed your gains for the year, you can use up to $3,000 in losses to offset other income that year. And if your excess losses exceed $3,000, the remaining amount can be carried forward to subsequent years.
When you file IRS Form Schedule D, your capital gains and losses will offset each other, and any excess loss can be carried over to your 1040.
Here’s a list of robo advisors we’ve reviewed that currently offer tax-loss harvesting:
|Robo-Advisor||Annual Fees||Minimum Deposit|
|Betterment||Digital – 0.25%/year; Premium – 0.40%/year||$0|
|Charles Schwab Intelligent Portfolios||None||$50,000|
|OpenInvest||0.50% (plus an additional 0.22% if you opt for the green bond fund)||$3,000|
|SigFig||First $10k managed free; 0.25%/year for $10k+; 0.50% for Diversified Income Portfolio||$10,000|
|Wealthsimple||$0 to $100k – 0.50%/year; $100k+ – 0.40%/year||$0|
|WiseBanyan||None — Basic services are free||$0|
Taxes are an important consideration for any investor, and there are steps that can be taken to manage your portfolio in a more tax-efficient manner. While this is important, be sure you aren’t focused on lowering your tax bill at the expense of your potential investment returns.
Also note that decisions as to which investments should be included in which types of accounts should not be made blindly with only tax implications as the deciding factor. Any questions you may have about taxes and your investment accounts should be directed to a professional.