We often joke that at Halpern Financial, our job is to “find change in the couch cushions” for our clients. And it’s true—we are vigilant about keeping expense ratios down, providing benefits of scale for our clients via our Institutional platform, and identifying planning opportunities that will save our clients money. However, this just scratches the surface. There are so many ways to save on costs—and one of the biggest ways is tax efficiency.
We are not CPAs, but we do keep tax efficiency at the forefront of our portfolio construction and financial consulting. We all have to pay taxes, but a tax-efficient strategy ensures we do not pay more than necessary. (After all, who wouldn’t want a “discount” equivalent to your tax bracket?)
What does a tax efficient investment strategy entail?
The right investment in the right type of account:
As part of a diversified portfolio, investors should own a wide variety of asset classes and funds. Not all are inherently tax efficient This is why it is important to keep less efficient types of assets in tax-deferred accounts (taxed upon withdrawal of funds) and more tax-efficient assets in taxable accounts (taxed annually).
For example, municipal bonds can be triple-tax-free. The interest they pay out is tax-free at the federal level, and if you have state municipal bonds, they are also exempt from state and local taxes. Keeping a muni bond in a tax-deferred account like a Roth IRA or 401(k) is kind of like carrying two umbrellas. (It’s just not that beneficial.) It is best to keep them in a taxable account because they are so tax efficient.
On the other hand, you would not want to keep Treasury Inflation Protected Securities (TIPS) or precious metals funds in a taxable account. These types of assets can generate burdensome taxes, so it is best to keep them in a tax-deferred account if they are a necessary part of your allocation.
The “traditional” (read: outdated) method was to put all equities in taxable accounts and all bonds in tax-deferred accounts. This was before tax efficient bond funds were available, and unfortunately, this strategy sacrifices growth potential while generating an unnecessary tax liability from equities every year.
Tax efficient distribution strategy:
For many retirees, their main question is “Will I have enough to live comfortably in retirement?” Halpern Financial’s Retirement Income Security Plan (RISP) report answers that question. We look at each client’s mix of accounts, pensions, and other income sources to make the puzzle fit together in a tax efficient way. A tax efficient withdrawal strategy can help assets last longer!
How? Remember, compound interest is extremely powerful in tax-deferred accounts. Because taxes are not being taken out annually, the growth is staggering compared to a taxable account!
This chart shows the growth of $100,000 in a tax-deferred versus a taxable account over 30 years, assuming a tax rate of 32% and annual growth of 8%. Over a 30-year period with these conditions, the taxable account would grow to $489,961 because taxes are taken out annually. Meanwhile, the tax-deferred account would grow to $1,006,266 because it is not taxed until withdrawal!
So why not only use tax-deferred accounts? Well, remember, Uncle Sam owns about 30% of that account’s growth, so you need to take out enough for your withdrawal plus enough to account for taxes. Each type of account has its advantages so it is beneficial to have both.
At Halpern Financial, we take a holistic view of the retirement income sources available to each client (including taxable, tax-deferred, and tax-free accounts if available, plus pensions or other income). We determine a retirement funding strategy that creates longevity of income and avoids unnecessary tax.
Even your emergency fund/cash reserves can be tax efficient.
Having proper cash reserves is necessary for many reasons, and tax efficiency is just one of them. If you do not have proper cash reserves and you need to pull money from your portfolio unexpectedly, assets might need to be sold to generate the cash. If you are selling at a gain, you may have a tax liability. If instead you have the proper cash reserves, you can avoid tax-inefficient portfolio transactions.
For even more tax efficiency: If you are putting aside money for a particular goal, you could use a municipal bond fund with duration equivalent to the timeframe of your goal. This allows you to earn a little more interest than you would in a savings account, without taking on excess risk—and that interest is tax free!
Increase After Tax Rate of Return
When it comes to investments, you keep what you don’t pay for. Saving on taxes is one of the most effective ways to stack the deck in your favor, and accelerate account growth. In taxable accounts, we attempt to limit factors that cause tax liability for each client.
One way we achieve this in taxable accounts is by minimizing the “turnover ratio” of funds—how often the fund manager changes the holdings of the fund. Every time the manager sells at a gain, the capital gain passes through to the investor. It’s good to have your investments grow, of course, but overly high turnover ratios create unexpected taxes and reduce the return of the portfolio in ways that are hard to calculate.
We also bill in a very tax-effective way by intentionally choosing which account the advisory fees are paid out of. It used to be that investors could deduct their advisory fees on their taxes, so it often made the most sense to bill from taxable accounts. However, the moment the most recent tax law changes went into effect, we adapted our billing to what was best for each client’s situation. As part of that consideration, we looked at every aspect of a client’s situation. For a young investor, we might prioritize the compounding periods of a tax-deferred account, but for most clients, we now bill from traditional IRA accounts. Because those accounts are tax deductible, it is like paying for something with tax-free money. It is like getting a discount equivalent to your tax rate on your advisory fee!
College saving strategy
Many states offer a state tax deduction for residents who contribute to their 529 Plan. Some states have a cap on the amount you can deduct, while for others it is unlimited! If you have children or grandchildren and would like to save for their educational expenses, this is a very effective way to save on state taxes.
When various asset classes move up and down, your portfolio allocation can veer off course. For example, if you have a portfolio with 50% equities and 50% fixed income, and equities triple in value—you now have a portfolio with 75% equities and 25% fixed income.
Of course, that is an extreme example, but smaller moves occur as a regular part of market mechanics. This is why we rebalance the portfolio (bringing it back to the intended allocation) regularly.
However, any time you have a sale in your portfolio, there is the possibility of taxes. We intentionally minimize taxes during the rebalancing process in several ways:
- Tax loss harvesting: A process in which we use losses in the portfolio to offset taxable gains. We maintain the proper allocation using equivalent fund swaps. The investor has a loss on paper but owns the same percentage of underlying stock in the allocation as before the sale.
- Rebalancing when it is beneficial. We’ve internally set limits on the amount of realized gains we are willing to tolerate for a client and we never rebalance just for the sake of doing it. Some advisors feel the need to move assets to justify their fee. As a fee-only, fiduciary advisor, we only do it when warranted.
- No trading or transaction cost– We only use funds that trade without a transaction fee. There is no cost to the client generated by rebalancing or tax loss harvesting transactions.
A good advisor should coordinate with your CPAs. At Halpern Financial, we compile tax packages for our clients, and we send it directly to their CPA if the client gives permission. This tax package details information your tax preparer needs to know about investment transactions that occurred throughout the tax year. We provide this information in a secure, digital format that saves the CPA time (and saves our mutual client’s money) because they do not need to input the data manually.
As always, consult your CPA before making any tax-related decisions. And share this post with him or her!