Tax-Efficient Investing: It's The After-Tax Return That Counts
To illustrate, suppose that a taxpayer (T) has $10,000 to invest for 40 years. The investment will grow at a pre-tax rate of eight percent. The following chart compares how much T would have at the end of the 30-year period with tax-free growth assuming various effective tax rates.
|
Tax Rate
|
Final Value
|
|
0%
|
$217,245
|
|
5%
|
$187,280
|
|
10%
|
$161,358
|
|
15%
|
$138,947
|
|
20%
|
$119,582
|
|
25%
|
$102,857
|
This blog entry provides an overview of tax-efficient investing, briefly addressing (1) the tax efficiency of various investment vehicles and management styles, (2) tax-aware asset allocation (3) tax-aware asset location and (4) investment incentives in the tax code.
Tax Efficiency
Some savings vehicles, assets, and management styles are more tax efficient than others. There are three general categories of retirement savings vehicles-- taxable investment accounts (e.g. brokerage accounts), tax-deferred accounts (e.g. 401(k) plans and traditional IRAs) and tax-free accounts (e.g. Roth 401(k) plans and Roth IRAs). Moreover, the taxable investment accounts could be invested in either capital gain or ordinary income assets and could be either actively or passively managed. To compare the after-tax results of the various retirement savings vehicles, assume the following general facts:
- T (age 30) has $5,000 of income to invest for 30 years
- Pre-tax rate of return …….…………………………………...………… 6%
- Ordinary income tax rate …………………………………...………… 30%
- Capital gains tax rate…………………………………………………......20%
Taxable Account
With a taxable account, the amount $5,000 will accumulate will depend on: (a) the type of asset purchased and (b) the management style. First, assume that T invests $5,000 in assets producing 6% ordinary income (e.g. interest income) each year. The 30% annual tax rate will reduce the after-tax rate of return to 4.2% (.7 x 6.0%). At the end of 30 years T will have $17,179.
Now assume instead that T has invested $5,000 in an account that produces growth instead of ordinary income (e.g. interest income). Assume further that the account is actively managed with all assets being sold each year, (but with the sales timed to qualify for long-term capital gain treatment). Under these facts, the account will grow at an after-tax rate of 4.8% per year. At the end of 30 years, T will have $20,408.
Finally, assume all assets are held for the full 30-year period and then sold. The value of the assets at the end of the time horizon would be $28,717, of which $23,717 would be taxable gain. The tax payable would be $4,743 (.2 x $23,717), leaving T with $23,974.
The points to be made here are simply that, all else being equal, growth assets are more efficient than ordinary income assets and passive management is more tax efficient than active management.1
Traditional IRA
By contributing $5,000 to a traditional IRA, T receives a $1,500 income tax savings ($5,000 x 30%). Assuming a 6% pre-tax rate of return on the $5,000 in the traditional IRA and a 4.8% return on the $1,500 in the taxable investment account after 30 years, the traditional IRA has grown to $28,717. The full amount is subject to tax at 30%, leaving $20,102 for T. The taxable account has grown to $6,123. T’s total wealth after tax is $26,225 ($20,102 + $6,123).
Roth IRA
If T contributes $5,000 to a Roth IRA, T does not receive an income tax deduction. The $5,000 will grow to $28,717 at the end of 30 years. There will be no tax when T receives the money, leaving T with the full $28,717.
Everything else being equal, an investment in a Roth IRA is more tax efficient than an investment in a traditional IRA unless the tax deduction can be invested in a tax-deferred account.2 The after-tax wealth from the various scenarios is summarized in the following chart.
|
FUTURE WEALTH CHART
|
|
|
Roth IRA
|
$28,717
|
|
Traditional IRA
|
$26,225
|
|
Taxable Account (LTCG) - Sell at end of 30 years
|
$23,974
|
|
Taxable Account (LTCG) - Active management
|
$20,408
|
|
Taxable Account (LTCG) – Ordinary income
|
$17,179
|
The foregoing analysis suggests that taxpayers should invest the maximum amount possible in tax-deferred accounts (e.g., IRAs and 401(k) plans) before investing in taxable investment accounts. In deciding among the different types of tax-deferred accounts, taxpayers may wish to contribute first to a 401(k) plan if the employer offers matching contributions. Contributions to a Roth IRA are generally more favorable than contributions to a traditional IRA, unless the taxpayer expects to be in a substantially lower marginal tax bracket during retirement than at the time of the contribution.
Tax-Efficient Asset Allocation
Research indicates that asset allocation is the most important factor in determining portfolio success. With tax-efficient investing, asset allocation is the same as conventional asset allocation except that it is done on an after-tax basis. All assets are first converted to their after-tax values and then asset allocation is performed in the usual manner.
Asset LocationSM (Taxable vs. Non-Taxable Account)
The basic asset location rule in tax-efficient investing is that the higher the tax on an asset, the more desirable it is to have the asset in a tax-deferred account. A rough ordering of investments from less desirable (from an income tax standpoint) to more desirable is as follows:
- Taxable bonds
- Money market funds
- Income-producing property (e.g., rental real estate)
- Real estate investment trusts (REITs)
- Actively-managed stock
- Tax-inefficient mutual funds
- Tax-efficient mutual funds
- Index funds
- Exchange Traded Funds (ETFs)
- Standard & Poor’s Depository Receipts (SPIDERs)
- Passively invested individual assets
- Stocks
- Raw land
- Precious metals
To illustrate, suppose that a taxpayer expects to pay income tax at a 40% rate (federal and state) after retirement. Further assume the taxpayer has a 50/50 allocation between stocks and bonds. In this case the taxpayer will hold the bonds in the traditional IRA and the stock in the Roth IRA. The total amount invested in the two IRAs is $100,000. Instead of having $50,000 in each IRA, the taxpayer should have $62,500 in the traditional IRA and $37,500 in the Roth IRA to equalize after-tax values ($62,500 x .6 = $37,500).3 The after-tax value of both the stock and bonds will both be $37,500 because the amount in the traditional IRA will be subject to a 40 percent tax.
Investment Incentives in the Tax Code
Finally, there are a number of special incentives in the Tax Code. The following is a partial list:
- Qualified dividends
- Long-term capital gains
- Qualified retirement accounts (e.g. 401(k) plan)
- Roth IRAs/Roth 401(k) plans
- Real estate depreciation
- Oil & gas
- Life insurance
- Non-qualified annuities
- Master Limited Partnerships (MLPs)
- Index options
Conclusion
You can learn more about tax-efficient investing by listening to my webinar. This on-demand webinar recording is free, and it is the first of the four-part Tax-Efficient Investing Webinar Series. The other three sessions can be viewed on demand for $20 each for A4A members and $30 each for non-members. Each of the four courses is pre-approved for CERTIFIED FINANCIAL PLANNER™ (CFP®) continuing education credit as well IMCA® CE credit toward CIMA®, CPWA®, and CIMC® designations. The following is a preview of Part 1 of the Tax-Efficient Investing Webinar Series.
[1] This is not to say that ordinary income assets do not have a proper role in a portfolio or that active management could never produce a higher after-tax return than passively-managed assets.
[2] Note that the tax efficiency issue outlined here is just one factor in deciding whether to invest in a Traditional IRA or in a Roth IRA. Other factors include the taxpayer’s marginal tax bracket at the time of contribution vs. the taxpayer’s marginal tax bracket when distributions are made and the special estate planning benefits of Roth IRAs.
[3] The proper proportions are calculated as follows. Let X equal the value of the stock in the Roth IRA—
X + X/.6 = $100,000
2.667 X = $100,000
X = $37,500.
This Website Is For Financial Professionals Only
