The story’s always the same: Brokers end up richer and customers end up broker.
TAX EFFICIENT FUND placement is an often underrated topic. The goal of the tax efficient fund placement is to minimize taxes within your investments, and select the right account for those investments.
But how much does that actually matter?
Vanguard’s research finds that a thoughtful asset location strategy can add significantly more value than an equal location strategy. The value added typically ranges from 5 to 30 basis points of after-tax return, depending on circumstances (e.g., income, portfolio size).
Investors generally have access to different account types, including:
If you are an employee that may not have access to a retirement plan, you could perhaps consider a Solo 401(k) if you have "side hustle" business income.
Generally, if your investments are all in tax-deferred or tax-free accounts, fund placement will not make a huge difference for you. That is because these accounts already come with tax efficiency.
If that's your case, two things become important though:
1. Consideration between pre-tax, like Traditional 401(k) or after-tax account, like Roth 401(k). Put simply, this decision generally comes down to your marginal tax rate now versus marginal tax rate in the future (which isn't something easy to predict due to the ever-changing tax landscape).
2. Account allocation. It becomes equally important where exactly you are investing. Roth accounts grow tax-free and qualified withdrawals are tax-free. You likely don't want to hinder that growth by choosing conservative assets (like fixed income, Money Market Funds, and so on).
Tax-efficient fund placement becomes extremely important when you also have a taxable brokerage account, along with tax-advantaged accounts. Many funds pay dividends and distribute capital gains if placed in your taxable brokerage account. At the end of the year, you receive a 1099 with that income and must pay taxes on the dividends and certain distributions.
One thing to call out from history is that you generally shouldn't hold Target Date Retirement mutual funds (or any "proprietary" funds) in your brokerage account. This is because unexpected redemptions could cause a huge tax bill.
You may remember a Vanguard 2021 fiasco where Vanguard opened an institutional TDF to more investors (lowered the minimum investment from $100M to $5M), which caused smaller retirement plans to sell out of individual funds and move into the institutional fund. This triggered massive unexpected capital gains for anyone invested in the individual funds if held in a brokerage account.
All of those unnecessary taxes could've been avoided by:
Let me give you a simple example:
Let’s say you are in a 22% federal tax bracket and a 5% state tax bracket, and you have some money invested in a dividend fund like Schwab US Dividend Equity ETF (SCHD). SCHD dividends are generally qualified, which means that the dividends get preferential treatment at a 15% federal tax rate for this investor.
The dividend yield is 3.43%. Considering the tax rates, the tax drag is (15% + 5%) * 3.43% = 0.686%.
To put this in perspective, a $10,000 investment will yield ~$343 in annual dividends. The tax impact on that investment will be $60.86.
Of course, if that money was in a Roth IRA, you would pay $0 in taxes on dividend distributions. Alternatively, this is something you may need to decide whether a dividend-focused investing strategy is the right one for you. For example, a Total US Stock Market ETF could have almost 3x less tax drag, and potentially more growth.
As someone in their 20s (who is subject to the Net Investment Income Tax) my focus is 100% on a growth investment strategy, rather than income generation. For someone in their 60s, that strategy could be different (even though selling shares for capital gains is better from a tax timing point of view).
A few more important points:
REIT stocks/ETFs are the least tax-efficient asset class to hold in a brokerage account because their distributions aren’t qualified, so you pay more tax (even though it may qualify for a 199A deduction).
Stocks that don’t pay dividends are the most tax-efficient to hold within your taxable account (Adobe, Amazon, Netflix, and others). However, holding individual stocks may not be the best strategy from an investment and diversification standpoint.
A big benefit of a taxable account is that the money is always easily accessible (liquidity), and you can control your withdrawal timing. While there are strategies that allow you to withdraw from retirement accounts before age 59 (like Rule of 55, 72(t) SoSEPP, Roth conversions), a brokerage account is more flexible. Therefore, analyzing the contributions and investments that go into this account is crucial.
How do you maximize tax efficiency? Let us know in the comments!
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.NO. 6: OUR FINANCIAL life involves endless tradeoffs. We usually have a good idea of what our dollars are buying us. But to be good stewards of our wealth, we should also ponder what we’re giving up.
NO. 27: COST-CONSCIOUS investors can save thousands over their lifetime. Take two investors who salt away $5,000 a year for 40 years. One pays 1% of assets in annual investment costs, while the other incurs 0.1%. If both earn 5% a year before expenses, the cost-conscious investor will amass $618,000, while the high-cost investor garners $494,000.
MARKET PORTFOLIO. This is the investable universe—all securities available for purchase. It consists of four sectors of roughly similar size: U.S. stocks, U.S. bonds, foreign stocks and foreign bonds. This is what all investors own and reflects our collective judgment of what securities are worth. Arguably, if you own a different mix, you’re making a market bet.
NO. 112: ALL-TIME highs in the stock market shouldn’t cause alarm. Investors often get unnerved when they see the Dow Jones Industrial Average or the S&P 500-stock index hit one new high after another. But because share prices trend upward over the long haul, all-time highs happen often—and don’t necessarily signal an imminent market downturn.
NO. 6: OUR FINANCIAL life involves endless tradeoffs. We usually have a good idea of what our dollars are buying us. But to be good stewards of our wealth, we should also ponder what we’re giving up.
I noticed that in the post by Dick Quinn – beyond-fees-is-using-a-financial-advisor-advisable , couple of folks had mentioned having flat-fee advisors. I see that it is lot easier to find advisors that charge a % of the assets under management but one that I am not fond of.
Have read mixed reviews about FACET, have found two sites that have flat-fee FAs
https://www.flatfeeadvisors.org/
https://saragrillo.com/2022/03/14/flat-fee-financial-advisors/
Are there other resources that one can look up?
Part of the “holistic”
Thank you Jonathan for as always, for your willingness to tell your story, the good and the bad.
I have one big mistake to get out there.
About 10 years before my wife and I retired, I started getting interested in money. I educated myself about index versus managed funds, fees, etc. While both of us had sizable 403b accounts that were tied up at work, I put all our after tax money in Vanguard. When we retired,
“NICE OFFICES,” OFFERED the 30-something investor, as he cast a wary eye across the corporate art, barren desks and empty bookshelves.
“Yeah, we asked management if they could put us on the 12th floor, so our suite number could be 12b-1. Funny, right?” The financial salesman winked.
“Not sure I get it.”
“It’s a joke, but clients never get it, they pay it.”
“What qualifications do you have?”
“See those initials after my name?
I met with a Vice President of Fisher Investments, a very large and very well-advertised fee-only investment advisory firm, to see if they would be a good fit to manage my portfolio. It turns out they weren’t, and after they asked why, this was my reply:
Frank,
Thanks for taking the time to meet with me to explain how Fisher Investments works.
I respect you for asking for feedback. And since you asked:
1. I’m not a fan of the fee structure:
-Its size: Paying you $70,000 a year to manage my portfolio seems like an awful lot of money.
WHEN IT COMES to communication, I’m kind of a fanatic. (My wife would say I should drop the “kind of.”) More specifically, I’m a fan of responsive communication.
Back in my working days, when I practiced criminal law, I made it a point to return phone calls and emails from clients promptly. It was rare that I didn’t do it the same day. If that meant staying late at the office until I caught up,
AFTER TAKING THE Series 65 exam in February, I set a goal for 2019: Help 10 friends and family members with their finances. Instead of giving specific investment advice, I wanted to educate them on money matters. I knew that they would benefit from one-on-one discussions, well-regarded books, educational videos and credible websites. But I also suspected that some might hesitate to talk to me about their finances. Nonetheless, I gave it a try.
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TAX EFFICIENT FUND placement is an often underrated topic. The goal of the tax efficient fund placement is to minimize taxes within your investments, and select the right account for those investments.
But how much does that actually matter?
Vanguard’s research finds that a thoughtful asset location strategy can add significantly more value than an equal location strategy. The value added typically ranges from 5 to 30 basis points of after-tax return, depending on circumstances (e.g., income, portfolio size).
Investors generally have access to different account types, including:
If you are an employee that may not have access to a retirement plan, you could perhaps consider a Solo 401(k) if you have "side hustle" business income.
Generally, if your investments are all in tax-deferred or tax-free accounts, fund placement will not make a huge difference for you. That is because these accounts already come with tax efficiency.
If that's your case, two things become important though:
1. Consideration between pre-tax, like Traditional 401(k) or after-tax account, like Roth 401(k). Put simply, this decision generally comes down to your marginal tax rate now versus marginal tax rate in the future (which isn't something easy to predict due to the ever-changing tax landscape).
2. Account allocation. It becomes equally important where exactly you are investing. Roth accounts grow tax-free and qualified withdrawals are tax-free. You likely don't want to hinder that growth by choosing conservative assets (like fixed income, Money Market Funds, and so on).
Tax-efficient fund placement becomes extremely important when you also have a taxable brokerage account, along with tax-advantaged accounts. Many funds pay dividends and distribute capital gains if placed in your taxable brokerage account. At the end of the year, you receive a 1099 with that income and must pay taxes on the dividends and certain distributions.
One thing to call out from history is that you generally shouldn't hold Target Date Retirement mutual funds (or any "proprietary" funds) in your brokerage account. This is because unexpected redemptions could cause a huge tax bill.
You may remember a Vanguard 2021 fiasco where Vanguard opened an institutional TDF to more investors (lowered the minimum investment from $100M to $5M), which caused smaller retirement plans to sell out of individual funds and move into the institutional fund. This triggered massive unexpected capital gains for anyone invested in the individual funds if held in a brokerage account.
All of those unnecessary taxes could've been avoided by:
Let me give you a simple example:
Let’s say you are in a 22% federal tax bracket and a 5% state tax bracket, and you have some money invested in a dividend fund like Schwab US Dividend Equity ETF (SCHD). SCHD dividends are generally qualified, which means that the dividends get preferential treatment at a 15% federal tax rate for this investor.
The dividend yield is 3.43%. Considering the tax rates, the tax drag is (15% + 5%) * 3.43% = 0.686%.
To put this in perspective, a $10,000 investment will yield ~$343 in annual dividends. The tax impact on that investment will be $60.86.
Of course, if that money was in a Roth IRA, you would pay $0 in taxes on dividend distributions. Alternatively, this is something you may need to decide whether a dividend-focused investing strategy is the right one for you. For example, a Total US Stock Market ETF could have almost 3x less tax drag, and potentially more growth.
As someone in their 20s (who is subject to the Net Investment Income Tax) my focus is 100% on a growth investment strategy, rather than income generation. For someone in their 60s, that strategy could be different (even though selling shares for capital gains is better from a tax timing point of view).
A few more important points:
REIT stocks/ETFs are the least tax-efficient asset class to hold in a brokerage account because their distributions aren’t qualified, so you pay more tax (even though it may qualify for a 199A deduction).
Stocks that don’t pay dividends are the most tax-efficient to hold within your taxable account (Adobe, Amazon, Netflix, and others). However, holding individual stocks may not be the best strategy from an investment and diversification standpoint.
A big benefit of a taxable account is that the money is always easily accessible (liquidity), and you can control your withdrawal timing. While there are strategies that allow you to withdraw from retirement accounts before age 59 (like Rule of 55, 72(t) SoSEPP, Roth conversions), a brokerage account is more flexible. Therefore, analyzing the contributions and investments that go into this account is crucial.
How do you maximize tax efficiency? Let us know in the comments!
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational.
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