All else equal, we all want to pay as little tax as legally possible. For do-it-yourself investors, one of the biggest challenges is choosing which funds to invest in. Unfortunately, fund selection is often done without considering the type of account the security will be purchased for. Though ‘tax-sensitive’ mutual funds might sound like a great option, they’re actually quite inefficient at maximizing portfolio growth when held in an IRA.
What’s a tax-efficient fund?
Though called many names (tax-aware, tax-managed, tax-advantaged are a few), the basic premise is the same: the tax implications of investment decisions are considered in the daily management of the fund, even at the expense of performance at times. There are several ways fund managers can reduce taxes in a mutual fund: minimize asset turnover, avoid dividend-paying stocks, increase the asset holding period to qualify for long-term capital gains, or find tax-loss harvesting opportunities.
The downside of tax-managed funds is that the manager must weigh expected performance with the tax cost to minimize the tax drag, which can hurt performance compared to a regular mutual fund. Further, due to the specialized management style, these funds usually cost more than comparable funds (through a higher expense ratio), which also eats into an investor’s return.
For investors in a high marginal tax bracket, the trade-off may be worthwhile to maximize their after-tax wealth, but there are other issues to consider, such as other investment vehicles such as ETFs.
An IRA is already tax-efficient
Retirement accounts such as an IRA or 401(k) are ‘tax-deferred’, meaning (as the name suggests) that tax on the investment growth is postponed until the funds are withdrawn down the road. In non-retirement accounts such as a brokerage account, investors must pay taxes annually on dividends, interest, and capital gains they received throughout the year. Especially for individuals with sizable brokerage accounts, it often makes sense to use funds from the account to cover the associated tax liability.
The power of compounding and concept of the time value of money make tax-deferred growth the most significant benefit of retirement accounts. Since compounding enables investors to earn a return on previously incurred investment returns, tax-deferred retirement accounts have the potential to grow more quickly than taxable accounts as funds don’t have to be withdrawn to pay taxes annually.
Investors don’t pay tax on investment growth in IRA accounts until the funds are taken out, so it doesn’t make sense to sacrifice a higher expected return in favor of tax savings, because there isn’t any tax due! All else equal, the only thing tax-efficient funds do in a retirement account is slow the growth of the account, which is certainly not the objective.
Investors can also miss a growth opportunity by selecting a ‘tax-free’ municipal bond fund in their retirement account. Income from a municipal bond (called “muni”) is tax-free on a federal level, though you may still owe capital gains tax depending on the fund’s investment activity. Further, buying a municipal bond issued by your home state also has tax advantages as most states and local governments do not tax income from their own bonds.
Like other tax-conscious funds, the downsides of municipal bonds include lower yields and higher fees. As with any investment, there are a host of other considerations to be aware of before investing, and municipal bonds are certainly no exception.
As discussed above, since investors defer taxes on retirement accounts until the funds are withdrawn, the tax advantages from municipal bonds are lost.
Location, location, location
When buying a house, you need the home and the location to work for you. The same goes with investing: it isn’t enough to pick the right funds; you also need to consider the type of account the asset will be located in.
It may seem easier to manage each investment account as its own stand-alone asset allocation, but it’s hardly the most efficient way from a tax, cost, and growth perspective. By considering your entire portfolio of accounts (taxable and tax-deferred) as one pool of investable assets, you can choose which funds are best suited for each account type.
For example, ETFs are structured to be very tax-efficient investments, making them a great potential candidate for taxable brokerage accounts, along with index funds which are passively managed and have lower turnover than an actively managed fund. Keeping relatively tax inefficient investments, such as high dividend yield mutual funds, REITs, and bond funds, in tax-deferred accounts also has its advantages.
There’s a lot to think about when developing your investment strategy and it’s always important not to let the tax-tail wag the dog.
This article was originally published by Darrow advisor Kristin McKenna, CFP® by Forbes.