When evaluating an investment portfolio, most people tend to focus on the return it provides. This is certainly understandable, as it is fairly intuitive. “I put in $100; it’s now worth $110. Therefore, my return is 10%.” However, this leaves out a key part of the overall story – taxes.

Broadly speaking, from the standpoint of most investment and tax professionals, investments can generally be classified as either “tax-efficient” or “tax-inefficient.” I’ll loosely define these terms as follows:

Tax-efficient investments are structured to minimize an investor’s tax liability, helping to maximize after-tax returns. This can be done through a deferral of taxes, a reduction of current income associated with the investments, or an expectation that future profits will be taxed at more favorable long-term capital gains tax rates.

Examples of tax-efficient investments may include:

• Certain individual stocks
• Low-turnover mutual funds
• Exchange-traded funds
• “Direct-Indexing”
• Certain real estate investments
• Municipal bonds
• Private equity/venture capital

Tax-inefficient investments typically generate frequent taxable events and often produce income that is taxed at higher rates, reducing an investor’s after-tax returns.

Examples of tax-inefficient investments may include:

• Taxable bonds (e.g., U.S. Treasuries, corporate bonds, etc.)
• High-yield stocks or bonds
• Private credit/lending strategies
• Hedge funds

Since investors can only spend after-tax returns, one might wonder why anyone would choose tax-inefficient investments. Two answers immediately come to mind, which apply to many high-net-worth investors –  diversification and a desire to reduce risk.

Many tax-inefficient investments have strong track records of producing good returns, often with little correlation to traditional investments like stocks and bonds. Furthermore, these investments may provide much more consistent returns than what one can expect from investments such as public equities (i.e. “the stock market”), private equity, venture capital or real estate. For many of our clients who have already amassed significant net worth, protecting against the downside is of greater concern than maximizing return (which, of course, requires taking more risk).

If you’re still with me and accept the premise that so-called “tax-inefficient” investments can add meaningful value, let’s discuss some ideal ways to incorporate these investments into a portfolio.

Account Types

Many high-net-worth investors hold significant portfolio assets across various types of accounts. When focusing on tax efficiency, it is imperative to first understand how different types of accounts are taxed. 

“Taxable” accounts such as individual brokerage accounts, joint brokerage accounts, and Trusts are subject to taxation when the following events occur:

• Dividend income is received
• Taxable interest income is received
• A capital gain is realized (i.e., an asset, such as a stock, is sold for a profit)

As a result, it is generally preferable to hold “tax-efficient” investments in “taxable” accounts.

“Tax-Deferred” accounts, such as Individual Retirement Accounts (“IRAs”), 401(k)s, 403(b)s, and annuities, offer certain benefits that taxable accounts do not. In tax-deferred accounts, when dividends are collected or interest payments are made, there is no taxable event at that time. Similarly, there is no taxable event when capital gains are realized. Taxes are generally only paid when distributions are taken from a tax-deferred account, but that’s irrespective of any investment activity and thus not relevant to the purposes of this article.

“Tax-Free” accounts such as Roth IRAs and Roth 401(k)s function similarly to tax-deferred accounts in that there is not a taxable event when dividends are paid, income is received, or capital gains are realized.

Tax-free accounts can also be a great place to hold tax-inefficient investments, though it is often preferable for high-net-worth investors to use tax-free accounts for their most aggressive investments that strive for maximum long-term growth…irrespective of tax efficiency, or lack thereof.

Implications

Since taxable accounts do not provide the same advantages as tax-deferred or tax-free accounts, it is generally preferable to hold “tax-efficient” investments in “taxable” accounts (all else being equal).

Conversely, because of the inherent advantages offered by tax-deferred accounts, these are often a great place to hold “tax-inefficient” investments.

Of course, these comments are painted with a very broad brush. A phrase I often use with clients is to “not let the tax tail wag the dog.” In other words, we should not make investment decisions based primarily on the tax implications. There are myriad factors that might lead to an investor holding a tax-inefficient investment in a less-than-desirable account type. Rarely do investors, or their advisors, get to build the desired portfolio with a completely blank canvas, without any constraints for liquidity, position sizes, etc.

For example, someone who sells a business for $20 million cash may end up with nearly all of his/her assets in “taxable” accounts. This person may still seek the benefits that can come from investments that are otherwise “tax-inefficient,” and there would be no practical way to optimize the location of these assets.

Having said that, once a portfolio strategy is chosen, it is incumbent on any investment professional to think about ways to mitigate current and future taxes during implementation.

I’ll conclude with a story that shows real dollars that can be saved by being mindful of taxes when investing:

Real Life Example

A few summers ago, when meeting with a longtime client (a married couple), we decided to invest $400,000 of cash that had recently become available into various “private credit” investments. At the time, they were apprehensive about adding to the stock market, but were not excited about the low interest rates offered by traditional bonds. They felt that the private credit funds that we recommended fit nicely with their objectives.

The cash was sitting in their checking account, so it could only be deposited into one (or both) of their revocable Trust investment accounts. There was no way to put this money into a tax-advantaged account such as an IRA or a 401(k).

At the time, part of this client’s investment portfolio included a 401(k) account that held roughly $1 million of a large-cap stock fund that provided broad exposure to the U.S. stock market.

With an eye on future tax savings, we recommended the following implementation plan:

• Invest the $400,000 of cash into a “direct index” strategy that seeks to track the S&P 500 while doing tax-loss harvesting.
• Concurrently, to maintain the same stock market exposure, sell $400,000 worth of the stock fund in the 401(k) account. Then, rollover $400,000 from the 401(k) to an IRA, so that we could purchase the above-mentioned private credit funds in a tax-sheltered account.*

In doing so, the only change to the investment allocation was a $400,000 addition to private credit strategies. Regarding the client’s stock market exposure, we simply swapped the location of $400,000 of exposure from a 401(k) to a Trust. We could have easily just used the cash from their checking account to buy $400,000 of private credit in a taxable account and saved the hassle of rolling over money from one account to another. However, by jumping through these very minor hoops, the following has been achieved in just a few short years:

• ~$115,000 of dividends have been received from the private credit strategies, which would be taxable at ordinary income rates if these investments were held in a taxable account. Since these investments are held in an IRA, our clients haven’t paid anything in taxes attributable to these dividends.
  • At a 37% marginal tax rate, that’s roughly $42,000 of tax avoidance.
• Additionally, because the direct indexing strategy has performed in line with our expectations and achieved its tax-loss harvesting objectives, that investment has generated nearly ($95,000) of realized capital losses despite growing at an average annual rate of about 9% (with the gains being unrealized and thus not taxed).
  • Assuming a 23.8% capital gains tax rate for this client, that’s roughly an additional $22,000 of tax avoidance.

To be sure, situations like this are not always available and/or appropriate. Many factors still must be aligned for this type of outcome to occur. But as you can see, by focusing on the details and providing a highly customized solution, it’s possible to meaningfully reduce one’s tax bill without necessarily changing one’s investment strategy.

If this story resonates with you, we invite you to connect with our team.

*This was necessary because these investments were not available in the 401(k) plan.  Had they been available, there would have been no need to do a rollover.

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