Best Practices for Tax-Efficient Portfolio Management

Our guest for the video “Best Practices for Tax-Efficient Portfolio Management” is Michael Kitces. He is a financial planning expert and the head of planning strategy for Buckingham Strategic Wealth, co-founder of XY Planning Network and AdvicePay, and is the Chief Financial Planning Nerd for the advisor education platform Kitces.com and the Nerd’s Eye View blog.

Key Takeaways

• The basic rule for this usually is pretty straightforward. Anything that’s ordinary income may as well go inside of an IRA because it’s going to be ordinary income no matter what. That usually led to some kind of basic rule of thumb, like bonds that generate ordinary income go inside of the IRA and stocks that generate capital gains go in brokerage accounts so that you still get the capital gains treatment.
• Right now, we’re seeing bond yields are getting higher and suddenly, the value of tax-deferred compounding growth when I might get 5-plus looks very different than tax-deferred compounding growth when I was getting 2%. And so, one of the things even that we’ve always done with clients in our firm is revisiting asset location on an ongoing basis.

Christine Benz: Hi, I’m Christine Benz for Morningstar. The topic of asset location, not to be confused with asset allocation, has gained new importance now that yields are higher. I recently sat down with financial planning expert, Michael Kitces, to discuss how investors and their advisors should approach that question.

Michael, thank you so much for being here.

Michael Kitces: Absolutely. My pleasure. Appreciate the opportunity.

Benz: I’d like to talk about asset location, where to hold different types of assets, assuming I have multiple account types. This was a topic that was kind of hard to get excited about when yields were so low. It’s like, well, what difference does it make, really, if someone is getting a 1% yield or a 2% yield on their bonds? But now that we are meaningfully higher with income, which of course is taxed at ordinary income tax rates, can you share some thoughts on that asset-location question?

Kitces: Asset location to me has gone through an interesting evolution over the past 20-odd years that there’s really been a growing focus on it. So, if we go back to the 1990s—we only made Roths in the late 1990s, and frankly, IRAs and 401(k)s were still in their early stages of gaining momentum then. It’s really the past 20 years that we’ve seen much bigger IRA and 401(k) balances. We’ve gotten more ways to move money in and out of retirement accounts. The overall contribution limits have gotten bigger, so we’re able to get more dollars in there and we’ve got this third bucket of tax-free Roth that the asset-location decision on the one hand has become more complex and on the other hand means there’s actually just literally more dollars and more opportunity to do this well, like I have more money and more buckets to choose from, more choices means more economic benefit if I get this right and, conversely, more economic harm if I get this wrong.

When I look at these asset-location decisions overall, the basic rule for this usually is pretty straightforward. Anything that’s ordinary income may as well go inside of an IRA because it’s going to be ordinary income no matter what, whether you draw it out of an IRA or it’s taxed in taxable account, but at least you put it in an IRA, it’s tax-deferred and you can control the timing of when this gets recognized into the future when you take a withdrawal instead of today. And so, that usually led to some kind of basic rule of thumb, like bonds that generate ordinary income go inside of the IRA and stocks that generate capital gains go in brokerage accounts so that you still get the capital gains treatment.

The problem that though—and we published a lot of research around this back in the early 2010s—when interest rates got so low, I mean, coming off financial crisis down to near 0 for a while and barely 2% on intermediate Treasuries, the yields got so low that the irony is, taking a low-yielding investment and putting in a tax-deferred account doesn’t actually really do much for you. The difference between tax-deferred compounding growth versus not tax-deferred compounding growth on 2 is not actually that much different. There’s just not that much compounding that happens when the yield base is so low in the first place. Compounding is a very powerful thing in the long run, but compounding low numbers only compound so far; compounding big numbers compound at much bigger levels. And because of that, what we actually found in our research is that because the yields were so low and there was so little benefit to get tax-deferred compounding growth on bonds, it was often actually better to put stocks inside of the IRAs, even though you might convert capital gains to ordinary income because you could get tax-deferred growth for very long time periods.

If I look practically from any investor’s portfolio, even those of us that tend to buy and hold, most people I know who are even buy-and-hold-oriented, if I pull up their portfolio today and I say, “Oh, this is really cool, like, show me what you had in 1993.” It’s not the same. Investment markets were different. ETFs barely existed. We lived in a mutual fund world. You couldn’t even buy it on an online platform because that didn’t exist. The nature of markets themselves change, and from time-to-time funds change, offerings change. And even if you take like a very low-turnover portfolio, like a 10% turnover portfolio—so we’re only changing investments once a decade on average—if we actually look at how that adds up over 30-plus years, once-a-decade turnover still drags so much lost return over multidecade time periods that we found for investors with really long time horizons, it was still better to put the stocks inside the IRA, give up the capital gains treatment to avoid the tax drag of even very low turnover and to the extent you’ve got anything that’s a dividend yield, if you’re getting a portion of returns in dividends instead of capital appreciation, that’s essentially like forced turnover …

Benz: You have no control.

Kitces: … you have no control. It is coming through. You are getting taxed on it, which means you are experiencing the tax drag that goes with it, again, usually at preferential qualified dividend rates. But it’s an annual tax drag that again gets a little more turbocharged inside of an IRA. And so, we found for investors with long time horizons, the yields on bonds were low enough that there was some value to putting stocks inside of IRAs and getting that tax-deferred compounding growth.

Now, however, our investment realm starts to shift. Right now, we’re seeing bond yields are getting higher and, suddenly, the value of tax-deferred compounding growth when I might get 5-plus looks very different than the tax-deferred compounding growth when I was getting 2. And so, one of the things even that we’ve always done with clients within our firm is revisiting asset location on an ongoing basis. I kind of think of this as like you can make the priority list of what’s most important to put in the IRA, what’s most important to put into the brokerage account. And as your investment views or investment assumptions or just the investment environment changes, so too does the nature of the priority list. Maybe I’m more bullish on something and I think it’s really got a great return opportunity, so I’m pushing it out to the Roth. And then, it appreciates a lot and all of a sudden, I’m not as excited about it anymore and maybe I don’t necessarily want it in the Roth. Or in this case, maybe I was not so excited about putting my bonds in the IRA because it actually wasn’t worth much to get tax-deferred compounding growth. I may as well leave it in a brokerage account. If I’m tax-sensitive, I’ll just buy a muni bond in the brokerage account. Now, suddenly, as yields are higher, well, putting bonds inside of the IRA starts to look more appealing again.

And so, nature of asset location to me is just—it is actually something that is more dynamic than often we’re giving it credit for with the simple rule of thumb of like bonds in the IRA because they’re already ordinary income and stocks in the brokerage account because they’re already capital gains. The relative weightings of these investments means the optimal location as you’re adding new dollars can actually shift over time. That’s part of the nature of how this works.

Benz: Michael, this has been such a helpful discussion. We’ve covered a ton of ground. Thank you so much for being here.

Kitces: Absolutely. My pleasure. Thank you.

Watch “How Rising Yields Should Affect Asset Allocation for Retirees, Preretirees” for more from Christine Benz.