April 15 is approaching, and once you’ve sorted through your W-2s and 1099s to complete your tax return, take a close look at the income section on your Form 1040. How much investment income did you report? A lot?

If so, do you know how big a bite taxes took out of that income?

The impact is probably bigger than you think. As an advisor providing financial advice to Vanguard Flagship Services clients, I speak every day with do-it-yourself investors who could pay less in taxes each year on their investments. Paying less could potentially increase their returns—without adding risk.

What’s the missing ingredient in their portfolios? Tax efficiency.

Beyond muni bonds and index funds

Tax efficiency means more than just using tax-efficient funds, such as tax-exempt bond funds or buy-and-hold stock index funds—though both can play a role.

You can achieve optimal tax efficiency by putting all of your mutual funds in the right types of accounts—taxable or tax-advantaged—with an eye toward minimizing current and future taxes as much as possible. Minimizing taxes—just like minimizing costs—is important whether you’re saving for or living in retirement, because every dollar you save from taxes each year ups the power of your investments’ long-term compound returns.

Location, location, location

The key to optimal tax efficiency is “asset location.” In other words, hold tax-efficient investments in taxable accounts, and tax-inefficient investments in tax-advantaged accounts. Here are a few examples:

  • Hold as much of your bond allocation as you can in taxable bond funds and in tax-advantaged accounts, such as IRAs and employer-sponsored retirement plans.
  • Keep actively managed stock funds in tax-advantaged accounts (if the bond funds haven’t taken up all the room).
  • Use stock index funds in taxable vehicles, such as individual or joint accounts.

These approaches provide some subtle but powerful tax advantages. Taxable bonds generally deliver higher interest income than comparable tax-exempt bonds, yet that income is sheltered from taxes until withdrawals are made, which can be over the course of many years. Meanwhile taxes on pesky capital gains distributions from active funds held in IRAs and 401(k)s  are also deferred, while stock index funds tend to produce little to no annual capital gains distributions.

For a more in-depth look at the advantages and benefits of asset location, check out this Vanguard research paper.

Small differences, potentially big results

How much return can proper asset location add to a portfolio? It depends on your tax situation, but if you check out the scenarios in the white paper I mentioned above, you’ll see that the increases are fairly small in the first year.  However, those small increases can potentially add up to more dollars in your nest egg over time.  After all, taxes are costs that also can erode your portfolio as much as, if not more than, the typically low expenses of your Vanguard funds.

What’s more, asset location enhances potential returns without increasing risk. Your overall asset allocation—your ratio of stocks and bonds—should remain the same, being well aligned with your goals, time horizon, and risk tolerance.

More return, same risk. Who doesn’t want that?

Get that “aha” moment

Honestly, the majority of self-managed portfolios I review could use some asset location “remodeling.” The most common flaw I see is stock funds in a traditional IRA or 401(k), combined with taxable and/or municipal bonds in a taxable account. Using this approach means paying higher ordinary income taxes on stock gains (at withdrawal in retirement), and accepting lower income returns on bonds, on an after-tax basis.

I think many investors miss the logic of asset location because the concept is counterintuitive. Clients have told me, “It doesn’t make sense to put low-growth bonds in a long-term retirement account!” Or clients use “mental accounting” when building their portfolio, making decisions on each account independently, instead of viewing all of their accounts as one portfolio aimed at building wealth.

Like “buy low, sell high,” asset location is a paradoxical investing principle that runs counter to our emotional (or, some argue, logical) impulses. But when clients I’ve consulted with have really grasped the concept, it has resulted in some of the biggest aha moments that I’ve seen when it comes to helping people become better managers of their own money.

 

Notes:

  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • All investing is subject to risk, including possible loss of principal.
  • We recommend that you consult a tax or financial advisor about your individual situation.