The Benefits Of Tax-Efficient Asset Placement
In addition to tax loss harvesting, another principle we help implement is called tax-efficient asset placement. That sounds like a mouthful -- what does it mean?
In a nutshell, tax-efficient asset placement means setting up your portfolio such that your assets that produce a lot of income -- think income from bonds and REITs -- are placed in tax-advantaged accounts such as IRAs or 401(k)s. This allows the income to compound and grow over time, deferred from taxation, until withdrawn or distributed.
Asset placement can have a large impact on your investment returns if you have both tax-advantaged (retirement) and taxable accounts. Unfortunately, most investors don’t place their assets with this in mind.  Many investors simply mirror the same allocation in both their taxable and tax-deferred accounts, but this can cut down on post-tax returns. The mistake isn’t surprising because taxes and investments can seem complicated enough -- why complicate things further? But, after you’ve done the hard work to find a smart long-term investment strategy, it’s important to take the final step in making sure those asset classes are all put into the right accounts from a tax standpoint. Doing so can result in even more savings over the long term.
At FutureAdvisor, tax-efficient asset placement is standard practice in the algorithm we apply to clients’ portfolios. Our research indicates that this strategy could increase your returns by 10 basis points (or 0.10%) a year when compared to simpler asset placement strategies. 
To put that in perspective, if you’re saving for retirement over 40 years and want to have a million dollars by the time retirement comes, using an allocation strategy that isn’t tax aware could cost you over $30,000. These small details add up.
REITs (Real Estate Investment Trusts) offer a great example of how tax-efficient asset placement works:
REITs are an asset class that provides exposure to real estate as a way to potentially offer an attractive return. They also serve to manage inflation risk in a portfolio because as inflation increases, most often commercial and residential rents do as well. Given their unique traits, REITs are a core component of FutureAdvisor’s asset allocation. However, REITs are structured in such a way that, by law, they must return the majority -- typically 90% -- of their net rental income to investors each year.
When looking at other types of investments, or asset classes, some pay little to no dividends. For example, as of 2015, the yield on many REIT funds approached 4%, but general US equity funds yielded under 2%. Hence, REITs can generate almost double the taxable income of other stock investments in your portfolio.
For most investors, holding REITs in a taxable account can generate a material investment tax bill each year, thanks to the dividend payments. On the other hand, if you place REITs in a tax-advantaged account, (which we do as part of our tax-efficient asset placement strategy here at FutureAdvisor), then you can defer tax on the dividend, allowing it to be reinvested and grow through the decades.
When allocating your investments, you want to first place your least tax-efficient funds into tax-advantaged accounts. These funds are the ones, such as REITs, that generate the most taxable income. Once you have filled up those accounts, then begin placing your more tax-efficient funds into taxable accounts. This means that the exact approach to tax-efficient asset placement is unique to every investor based on their precise asset allocation and the relative availability of tax shelters within their portfolio. This sort of detailed customization of portfolios to the needs of individual situations is something that algorithms (such as those we use at FutureAdvisor) are able to do extremely well.
How does our algorithm’s tax-efficient asset placement work in our client portfolios?
Tax-efficient asset placement is just one consideration in our investment approach. Our algorithm is designed to balance tax-efficient placement against other factors such as optimizing your stock/bond split or investing new cash. It is designed to select the optimal trading decision when weighing a number of goals; it is designed to invest in the instruments that have the largest possible benefit (considering costs, diversification, tax efficiency, transaction costs, etc.) to your expected future returns.
Tax-efficient investing is particularly important for those who expect to be investing for at least a decade, have investments in both taxable (i.e., brokerage) and tax-advantaged accounts (such as Roth or Traditional IRAs), and meet some or all of the following criteria:
- Pay a high marginal income tax rate
- Are in a high income-tax state (such as CA or NY)
- Expect lower income taxes in retirement
- Possess many tax-efficient investments in taxable accounts
Tax-efficient asset placement decisions should also take into account:
- The tax basis of the investment
- Other needs within the portfolio such as ongoing rebalancing decisions
- The potential volatility of an asset class, since assets in a taxable account can be tax-loss harvested, which can also boost post-tax returns
Your tax efficiency will also depend on the ratio of your tax-advantaged account(s) to your overall portfolio. As an example, let’s say you have a $50,000 portfolio, divided into a $45,000 taxable account and a $5,000 IRA.
If your ideal bond allocation is 18%, you would have about $9,000 in bonds. (Additionally, your portfolio will have a few thousand dollars of REITs, which are considered stocks for asset allocation purposes.)
In order to be tax-efficient, first we “fill-up” your IRA by ensuring the $5,000 in funds consists of bonds and REITs. Then, because you have more than $5,000 of bonds and REITs per your asset allocation, we’ll put the remainder of those funds in your taxable account. This allows us to create the most tax-efficient portfolio possible given the constraints. In this case, the only practical way to improve your tax-efficiency is to increase the size of your IRA with additional contributions. So take comfort knowing you’re properly diversified across all asset classes, even if it means holding some bonds and REITs in a taxable account.
This is also why you may notice a difference in performance across your various accounts. Let’s say, for example, this year bonds return +8% while equities return -10%. Your IRA, which has more bonds and REITs, will likely have a greater rate of return for the year than your taxable account, which contains mostly equities. That’s why it’s important to consider your portfolio in entirety, and not each account in isolation, when evaluating performance.
Here is a chart of FutureAdvisor’s twelve asset classes, ranked by tax efficiency, as of May 2016. The most tax-inefficient assets are at the top (REITs, Bonds) and the most tax-efficient ones are at the bottom (Stocks).
FutureAdvisor uses ETF yield data and estimated tax-rate data to rank-order the twelve asset classes. Our algorithm then assigns a slight preference to place the most tax-inefficient assets in tax-advantaged accounts when possible. It is important to remember that the yield information is based on current yield rates and is subject to change. Additionally, because tax-efficient asset placement in only one of the factors our algorithm considers, therefore, it is entirely possible to sometimes see some tax-inefficient ETFs in a taxable account. This twelve asset class portfolio is key to developing a diversified investment strategy. Diversification means owning different types of asset classes, each of which have different tax characteristics. Tax-efficient asset placement understands these unique tax characteristics to build an optimal allocation for you across the different accounts you have. This is something that intelligent investment algorithms are well-suited to deliver. And it’s just one part of the tax efficiency we aim to deliver at FutureAdvisor, working in concert with our other advanced tax strategies such as tax-loss harvesting and capital gain-conscious rebalancing.
 Investment Company Institute (ICI) data
 Academic studies have estimated tax-efficient placement can add as much as 20 bps (0.20%) to a portfolio each year. However, our research is more conservative and estimates the savings to be closer to 10 bps (0.10%) per year. Daryanani, Gobind, and Chris Cordaro. 2005. “Asset Location: A Generic Framework for Maximizing After-Tax Wealth.” Journal of Financial Planning (18) 1: 44–54.
The views expressed are for informational purposes only and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by FutureAdvisor. All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions. The investment strategies mentioned are not personalized to your financial circumstances or investment objectives, and differences in account size, the timing of transactions and market conditions prevailing at the time of investment may lead to different results. Clients may lose money. Past performance is not indicative of future results. Investments in securities involve the risk of loss. Any tax strategies discussed should not be interpreted as tax advice and do not represent in any manner that the tax consequences detailed will be obtained. Clients should consult with their personal tax advisors regarding the tax consequences of investing.