Manage Households, Not Accounts, Or Risk Getting Fired! Hot

Each type of investment account has different tax and economic attributes.  When selecting investments to compose a diversified portfolio, some pieces of the allocation should be held in particular accounts rather than holding similarly structured diversified investments in each account. By managing at the household level, it is possible to minimize tax consequences while making the most of economic attributes.

For example, holding appreciating equities in an IRA (or retirement account) means that gains will ultimately be taxed at ordinary rates.  If these investments are held in a taxable account, gains will qualify for capital gain rates – which can be less than half of ordinary rates!  Also, if left to heirs, income tax can be completely avoided by taking advantage of basis step-ups.  Alternatively, inherited IRAs do not escape tax.

Fixed income investments may be more appropriately held in an IRA (or retirement account).  Income generated by these investments will be currently taxed when held in a taxable account.  Tax will be deferred if held in an IRA.  (It should be noted that choosing municipal bonds for taxable accounts will not necessarily negate the benefit from holding taxable bonds in the IRA, since, in general, yields on these bonds are discounted to account for tax savings.)

Finally, since Roth IRAs are not subject to tax, and are typically held long-term (and retained to leave as legacies), high return investments will take maximum advantage of this unique type of account.

If you don’t consider household level management, also called “location optimization”, you may be costing your clients big bucks.  Consider this simple example:

Dick and Jane’s desired investment allocation consists of:

            Bonds, expected return 4%:                                40%

            U.S. Stocks, expected return 8%:                       50%

            International Stocks, expected return 12%:          10%

For purposes of this example, we will assume that bonds have an expected return of 4 percent (ordinary income); U.S. stocks have an expected return of 8 percent (all appreciation) and international stocks have an expected return of 12 percent (all appreciation).  We will also assume that Dick and Jane’s ordinary tax rate is 30 percent and their capital gain rate is 15 percent. 

Advisor A manages Dick and Jane’s portfolio on an account level basis, as follows:

Advisor B manages Dick and Jane’s portfolio on a household level basis, as follows:

Based on a municipal bond return of 2.8 percent (4 percent less 30 percent tax equivalent), and assuming full liquidation after 5 years, Dick and Jane will realize the following net proceeds:

Account level management:  Pre-tax balances (total $1,383,835) and post-tax balances (total $1,192,811) after 5 years:

Household level management:  Pre-tax balances (total $ ) and post-tax balances (total $ ) after 5 years:

By utilizing household level management, Dick and Jane realize the following benefits over account level management after 5 years:

·                Additional pre-tax assets of $13,724

·                Additional after-tax assets of $23,550

Although a ‘‘perfect’’ allocation is usually not possible based on relative values in taxable and non-taxable accounts, household level management should always be considered.  Not doing so can cost your clients money and place your practice at risk. 

The material appearing in this article is for informational purposes only and should not be construed as legal, accounting, or tax advice or opinion provided by the author.

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