In today’s environment, transactions are easy. You can buy pretty much anything with the click of a button or using your face ID on your phone. You can purchase stocks/mutual funds/ETFs all while out to lunch with a friend.
As a result of our quick-click society, it’s easy to cross off items on your financial list. In fact, most successful people check all the financial planning “boxes” and rarely are they missing any products. They may have an IRA/Roth, they’re contributing to 401ks, have set up plans for their kids’ education, established wills and trusts, and many own income property, but those financial pieces have been acquired often piece-by-piece. Most have the investment philosophy of “this seems like a good idea, I’ll purchase that.” As each piece is acquired, the financial picture becomes more complex and there is little to no coordination amongst these assets.
To be clear, it’s not that there are inherent issues with a particular asset but, when evaluated in a larger scope, a given piece may not be the best fit or might be redundant. It’s important for an investor to think strategically in a way that unifies these assets and structures future assets to enhance the overall financial plan. In this article we will discuss the value of proper asset positioning, diversification and tax-loss harvesting to enhance overall portfolio efficiency.
The piece-by-piece approach to planning often misses opportunities for tax-efficiency. Each type of investment has different tax properties. While asset location is not a new investment concept, it’s not always implemented across a portfolio. At the simplest level, it’s placing assets in various types of taxable and tax deferred account to maximize after tax returns.
The most tax-efficient assets are put in taxable accounts, such as individual stocks to be held for at least a year (profit from the sale is taxed as a long-term capital gain), exchange traded funds (ETFs), U.S. treasuries, municipal bonds. The least tax-efficient assets are put in tax deferred or tax-free accounts, for example individual stocks to be held for less than a year (profit from the sale is taxed as ordinary income), taxable fixed income, mutual funds, real estate investment trusts (REITs).
A client’s overall investment allocation can be the same (60% stocks/40% bonds for example) across all accounts, but by strategically placing less tax-efficient assets in tax-deferred locations, the client’s tax adjusted return can be enhanced. The client’s pre-tax return might be the same on their statement, but what they keep after taxes could be greatly different.
Tax-loss harvesting and reducing capital gains distributions on mutual funds are opportunities to enhance tax-efficiency often missed by investors when assets aren’t properly coordinated. In an ideal world, all asset classes would only increase in value; unfortunately, that is not reality. Tax-loss harvesting is the selling of investments at a loss to offset taxable gains on profit-generating investments. There are many rules that an investor needs to be aware of when tax loss harvesting to ensure they are operating within the IRS guidelines.
Capital gains distributions are another consideration that can negatively impact portfolio returns. Under the Investment Company Act of 1940, mutual fund companies must distribute all or substantially all of their net investment income from dividends, interest, and realized capital gains to their shareholders each year in the form of a capital gains distribution. This distribution is typically determined towards the end of the year, and an investor should have a system to track potential distributions for mutual funds held in a taxable account. This allows an investor to evaluate the pros and cons of keeping or selling out of a potential fund before the record date.
Similarly, an investor should be conscious of investing in mutual funds in a taxable account before the record date (as you’ll be forced to pay the taxes even if you’ve not experienced any gains). That’s right, even if you don’t have any gains (or potentially even a loss in your account), you could still owe taxes if the fund makes a capital gains distribution. This is an unknown pain point for many investors and unless you evaluate and plan before the record date, it’s too late.
The last area often missed by implementing the piece-by-piece approach to planning is proper diversification. Diversification is a risk management strategy achieved through utilizing a mix of asset classes to limit exposure to any single asset or risk. In times of increased market volatility, a diversified portfolio may be less likely to experience declines in all asset classes which may lessen the aggregate decline across the portfolio.
Strategically, market volatility presents an opportunity to rebalance and bring all asset class weightings back to their originally intended allocations. Regardless of the reason for the market volatility (trade wars, pandemics, military conflicts, etc.), the combination of implementing both strategies – diversification and rebalancing - is relevant to effectively managing a portfolio. Cash and cash-equivalent assets also serve an important role in distribution planning. By always having cash on hand, you can reduce the risk you’ll be forced to liquidate assets at the wrong time.
The piece-by-piece approach to financial planning may underperform long-term due to lack of diversification, inefficient asset location, and missing opportunities for increased tax-efficiency. While having a plan that takes these factors into consideration can greatly enhance your retirement picture, it’s important to note that these are just a few factors when developing a long-term financial strategy. Having a well-thought-out, dynamic strategy focused on your specific goals and income needs is critical to long-term success.
This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.
All investments carry some level of risk. No investment strategy can guarantee a profit or protect against a loss. Diversification and strategic asset allocation do not assure profit or protect against loss.
Andrew James Watkins uses Triangle Wealth Advisors as a marketing name for doing business as representatives of Northwestern Mutual. Triangle Wealth Advisors is not a registered investment adviser, broker-dealer, insurance agency or federal savings bank. Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and its subsidiaries. Andrew James Watkins is a Registered Representative of Northwestern Mutual Investment Services, LLC (NMIS) (securities), a subsidiary of NM, broker-dealer, registered investment adviser and member FINRA and SIPC.
For more information and important disclosures, please visit: www.trianglewealthadvisors.com.
