Looking at tax efficiency in your investment portfolio

Ask most investors, and they will agree that minimizing taxes is an incredibly important part of investing to achieve long term goals. But do they really know what it means to them that tax rates differ between W2 wage earners and Capital Gains for investors and how to use this knowledge? The difference in rate is very high now with a top rate of 37 and 20 percent respectively. Most investors are aware of this difference but occasionally act in ways contrary to this information.

For example: You have a balanced 50/50 stock bond allocation and put it all in a 401(k) seeking the largest amount of tax deferral and employer matching contribution. This makes sense as the deferral value will exceed the future penalty of having stock gains taxed as ordinary income when it is distributed from the 401(k).

What does not make sense is if you also have an equal amount of money in a taxable account invested in the same 50/50 allocation. In this case, you are needlessly taking capital gains on ordinary income. Instead you need to locate your stocks in the taxable account and bonds in the 401(k). In addition, you lose the option to write-off any losses against other gains.

In an extreme example, if you save $1,000,000 in a 401(k) and then liquidate it, you have $630,000 left to spend. If instead you have $500,000 in a 401(k) and $500,000 in a taxable account (with 0 basis) and liquidate both, you would end up with $715,000. The difference in wealth is $85,000 using the exact same assets.

This is why it is valuable to have a trusted Wealth Advisor that works with you to take a look at the whole picture of asset location and allocation, as well as account type, in order to align your investments for maximum tax efficiency. Once your portfolio is designed for tax efficiency, you and your Wealth Advisor will be on the way to successfully meeting your long-term financial goals.