4 Best Practices for Building a Tax-Efficient Portfolio

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“Morningstar. I m jeremy glaser. It s tax relief week here on morningstar comm and and i m joined today by christine ben s she s a director personal finance. ll look at four best practices for building.

A tax efficient portfolio. Christine thanks. Joining me jeremy great to be here when we re talking about tax efficient portfolios. We usually talking about taxable accounts.

Why should investors even consider taxable accounts given the built in advantages of an ira or 401k. That s a really good question. The first reason is liquidity or flexibility. So you might have some short term or even intermediate term goals that you need to finance prior to retirement and investing in a taxable account will give you by far the most flexibility in terms of pulling your assets out you also have the flexibility to invest in a lot of different investment types where there are some strictures certainly for investing in a 401k or usually choosing from a preset menu and even within an ira even though you have a huge degree of latitude about what you can choose for that ira.

There are at least some strictures regarding. What you can invest in inside of inside of an ira so flexibility and liquidity would be two key reasons. Another key reason would be simply for higher income investors who are already maximizing their contributions to those various tax sheltered account types. The taxable account may be their only option at that point and finally.

I would say especially for people who are accumulating assets for retirement. There s some advantage to coming into retirement with some assets in a taxable account. The reason is that if you have assets in that text bowl account that are eligible for capital gains treatment..


That s pretty favorable especially right now with capital gains rates as low as they are right now so in fact pulling money from a taxable account will generally be preferable from a in terms of your income tax in a given year to pulling money from a traditional ira or a traditional 401k. Where you ll pay ordinary income tax rates on those distributions your first best practice for building. A portfolio like this is that time horizon. Should really lead the way why is that well the key reason is that if you need safer assets.

If you need cash and bonds in your taxable portfolio. You should own them regardless of their tax treatment. So the income that you receive from cash and bonds is going to be taxed at your ordinary income tax rate. But let s face it income is pretty low in absolute terms certainly today and so the taxes that investors will owe on that income will not be generally speaking especially high in absolute terms.

Another key reason that investors shouldn t get too worried about owning shorter term securities in their taxable account. Is that they can own municipal bonds. If they re in a higher tax bracket especially that s going to be more advantageous than holding either taxable cash securities or taxable bonds securities in that taxable account. I often point people to the tax equivalent yield function on morningstar s bond calculator.

They want to kind of run the numbers about whether it s they re better off looking to some sort of a municipal bond or municipal bond fund versus investing in taxable bonds. So you can plug in your tax bracket and a little bit of additional information and see which of those products looks. Most advantageous once the tax effects are factored in the second best practice is to make sure that you employ either tax friendly equity strategies or at least avoid the ones that the most unfriendly how do you go about doing this well certainly. I think.

There s a lot of clarity around what are tax efficient equity strategies so broad market index tracking mutual funds broad market exchange traded funds are generally speaking very tax efficient equity types. I like the category of tax managed funds. So it s a pretty small group at this point..


I think vanguard suite in particular of tax managed. Funds is a really good. One and certainly. Individual equities can be a nice tax.

Efficient portfolio strategy. As well. The reason is that as an individual. An equity owner you exert a lot of control over when you realize capital gains so you exert a lot of control over your tax situation when i think about the various model portfolios that i ve built for example that are maintained and built with an eye toward tax efficiency.

I ve generally focused on these investment types. You mentioned etfs one of the big selling points for years has been their tax efficiency. Do you think this is a little bit overdone as a point that can you get tax efficient strategies outside of an etf you definitely can so when you look at the pairs of exchange traded funds and broad market traditional index funds that track the same index we see that both of these investment types tend to be pretty tax efficient and that s mainly because their index funds so their turnover is very very low. I will say though that etfs do have a little bit of an extra tax advantage due to their structure.

But in the case of say the vanguard traditional index funds versus. The vanguard etfs when you look at the numbers. When you look at our tax cost ratios for example. You see that it s generally kind of a wash in part because of vanguards particular structure for its etfs where their share classes of the traditional mutual funds.

But in general both traditional exchange traditional index funds and exchange traded funds are really good tax efficient strategies. Provided. Your fund is tracking some benchmark that doesn t reconstitute itself..


Very frequently on the flip side. How do you recognize a tax and efficient fund not a lot of them advertise themselves as being taxed and efficient right certainly high turnover is a big red flag and high turnover is particularly painful from a tax standpoint because if the fund is realizing short term capital gains those capital gains are taxed at ordinary income so that s a strategy that to the extent that you want to own it in your portfolio. You would want to own it in some sort of tax advantaged account any sort of fund that tends to own even though maybe it s predominantly equity. That owns other securities that are taxed as at your ordinary income tax rate.

So you sometimes see this with equity funds that own dividend paying equities. But they might also own a sleeve of convertible and preferred stock those would tend to be less attractive for a tax efficient portfolio. Another category would be funds that prioritize dividends so even though investors love dividend paying stocks because you don t exert control over when you receive those dividends to the extent that you can shelter that high dividend. Payer inside of a tax sheltered account that s a good practice as well and finally.

I would say that investors would want to take care with any sort of actively managed equity fund and i think. This is a lesson that we ve learned over the years and watching these funds be tax efficient for many years until they aren t so you might have a fund that s tax efficient because it s got a manager who buys and holds the basket of securities. That he or she likes and then that manager leaves and the new manager comes aboard switches up the strategy. Somewhat and the fund that was once quite tax efficient is not so tax efficient anymore so i would say as a as a general admonition investors need to be careful about owning actively managed funds within their taxable accounts just to be safe.

I do think it s better to think about index tracking products or tax managed funds if the best practice is about not being your own worst enemy. What do you mean by that well as i was saying about funds just as they can incur short term capital gains that are taxed as ordinary income so can you as an investor if you re trading around making changes yourself you can exacerbate your portfolio s tax inefficiency. So you can increase the drag of taxes on that portfolio so generally speaking. If you ve got a taxable portfolio.

A strategy of kind of benign neglect neglect is a good policy for that portfolio trading less will tend to trigger. Fewer taxable events in that account the first three best practices. Really focused in that accumulation phase..


But your fourth is about when you re in drawdown. What should investors keep in mind well investors if they read up on this on tax efficient distribution of their retirement assets. They might see some guidelines about sequencing withdrawals. I ve even written about this.

And what you often see is that if you are age 70 and a half or older absolutely you have to take your required minimum distributions from your traditional iras move on to your taxable accounts then move on to traditional texts deferred accounts then save your roth assets for last. But i think it s particularly valuable to try to maintain that tax diversification throughout retirement. So it s not like you want two sequential sequential ii plow through these accounts and then at the end be left just with roth assets. Ideally you d maintain that tax diversification and that allows you to be flexible on a year to year basis depending on what else you have going on with your taxes that year.

So if you find yourself in a particularly high tax year for whatever. Reason. And you need additional assets from your portfolio maintaining the taxable assets. Where you may be able to obtain capital gains treatments on some of your withdrawals can be really advantageous so ideally retirees would maintain some diversification among these different account types throughout retirement.

Not just. As they re accumulating in the years leading up to retirement. Kristine thanks for your tips today thank you jeremy for morningstar. ” .


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