Is Your Portfolio Tax Efficient?

Investors often spend decades focusing on how much to save, only to reach retirement and realize they have very little control over how much they keep after paying taxes. That's where tax diversification comes in.

What is tax diversification? It involves using a mix of account types with different tax treatments to help pursue long-term goals. By strategically managing your taxable, tax-deferred, and tax-free accounts today, you're building in flexibility to help navigate your future tax situation, whatever it may be.

The three basic types of accounts that all investors can consider for improving their tax diversification are taxable, tax-deferred, and tax-free.

Taxable accounts include ordinary brokerage investment accounts, as well as most bank savings accounts. You fund these accounts with after-tax dollars, and you pay taxes on any capital gains or investment income realized each year. Taxable gains and income generated by your taxable accounts can potentially be offset by losses or other adjustments to your income for the year.

Tax-deferred accounts include traditional IRAs and 401(k)s that you fund with pre-tax dollars. Your balances have the potential to grow tax-deferred over time. When you make a qualified withdrawal (including a Roth conversion), you pay ordinary income tax rates on the entire amount.

In a tax-free account, your earnings grow tax-free and qualified withdrawals are also tax-free. Contributions, however, are not always tax deductible. Some tax-free accounts are funded with after-tax dollars, such as Roth IRAs and Roth 401(k)s.

Other tax-free accounts are funded with pre-tax or tax-deductible dollars, such as health savings accounts (HSAs). HSA contributions are deductible from your federal income taxes, although not all states offer a state income tax deduction for contributions.

Finally, 529 college savings plans are a type of tax-advantaged account offering tax-free account growth and tax-free qualified withdrawals. Keep in mind that 529 contributions are not deductible from your federal income taxes but may be tax-deductible from your state income taxes (if applicable).

Generally, your most tax-efficient assets should be held in your least tax-efficient accounts, and vice versa. Here's where tax-smart investors typically put their investments.

• Individual stocks you plan to hold for more than one year
• Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds
• Stock or mutual funds that pay qualified dividends
• Municipal bonds, I bonds (savings bonds)

• Individual stocks you plan to hold for one year or less
• Actively managed funds that may generate significant short-term capital gains
• Taxable bond funds, zero-coupon bonds, inflation-protected bonds, high-yield bond funds
• Real estate investment trusts

Many of us are saving for multiple goals, including funding a comfortable retirement and helping our kids pay for college. When juggling competing priorities, consider funding your savings and investing accounts in this order:

1. Start with your company match. Save enough in your employer-sponsored retirement plan to get the full company match, if your employer offers one.
2. Consider HSAs next. If you have an HSA tied to your high-deductible health insurance plan, consider maxing it out to fully realize its tax benefits.
3. Max out your retirement savings. Contribute the full annual maximum to your tax-advantaged retirement accounts, including 401(k)s or traditional IRAs. Or increase contributions 1% – 2% a year until you reach the max.
   • If you're younger, in a relatively low tax bracket, and your employer offers a Roth 401(k) option, chat with your tax advisor about whether a Roth 401(k) might be a good fit for your situation.
   • If you're over 50 and want to make catch-up contributions to your 401(k), your catch-up contributions may need to be made to a Roth 401(k) if you have a higher income. Ask your tax advisor about directing your catch-up savings to a Roth 401(k) or a taxable brokerage account. Both could be good options.
4. Contribute to taxable accounts. Consider a taxable brokerage account to invest even more. There's no up-front tax break, and income is taxed in the year you earn it. But if you hold assets for more than a year, you may qualify for a lower long-term capital gains tax rate.
5. If you have kids or grandkids who might go to college, consider college-savings options last. Retirement should be your top priority before saving for other goals. Once you've maxed out your retirement accounts, then you can earmark any additional savings toward a 529 college savings plan if it makes sense for your tax situation and education funding goals.

Tax-loss harvesting—offsetting capital gains with capital losses—can lower your tax bill and better position your portfolio going forward. To harvest losses, you would typically sell an investment that's underperforming and losing money. Then, you use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income. Finally, you reinvest the proceeds from the sale in a different security that meets your investment needs and asset-allocation strategy.

Keep in mind that tax-loss harvesting is only applicable toward your taxable accounts—you don't need to harvest losses in your 401(k) or IRA accounts. Also, beware that wash sale rules apply.

A Roth IRA conversion involves moving assets from tax-deferred retirement plans into your Roth IRA. You pay ordinary income taxes on the amount being converted, with a goal of saving on future taxes down the road. It can be especially useful for people who expect to fall in a higher tax bracket in retirement, who want to maximize the value of their estate to their heirs, or who are experiencing lower-than-usual income in the current tax year.

It's a good idea to meet with a tax advisor or a CFP before executing a Roth conversion, as there are many complex considerations and conversions cannot be undone.

There can also be good reasons to avoid doing a Roth IRA conversion. For example, if you need to withdraw the money in the near future to cover living expenses, you may not have time to recoup the taxes you would pay for the Roth conversion. Also, it's usually better if you can pay any taxes associated with a Roth conversion with cash on hand, rather than selling assets to pay the taxes. Finally, if you're planning to donate a substantial portion of your traditional IRA to charity, you could use a Qualified Charitable Distribution in lieu of doing a Roth conversion if you are over age 70-1/2. Qualified Charitable Distributions can be complex, so it's a good idea to meet with a tax advisor before initiating any Qualified Charitable Distributions from an IRA.

Building a tax-efficient portfolio is not a one-time event, but rather an ongoing practice. The next article in our series, Is Your Tax Strategy Keeping Up With Your Life?, discusses the importance of reviewing your tax plan at least annually, as well as anytime you experience a major life event. By periodically reviewing and updating your tax plan, you can potentially grow your net worth over a lifetime.