You may be losing money by simply not understanding which accounts are the best place to hold your investments for tax avoidance. If you have holdings outside of a retirement account, you’ll want to know these tax efficient investing strategies. Let’s walk through a 10 step process to rebalance and stop paying Uncle Sam more than his fair share.
The following is a letter to my children showing optimal buckets for investments to reduce tax burden.
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Place your Funds in the RIGHT Account for Tax Efficient Investing
Dear DIY Investor,
Congratulations! You’ve expanded your investment portfolio beyond just retirement accounts and want to know the optimal placement for each type of holding. You need to consider the best account placement for Mutual Funds, Bonds, Target Date Funds, ETFs, Stocks, Index Funds, and REITs for efficient tax avoidance. There are also varying allocations within mutual funds that could have greater tax implications depending on which account the holding resides.
Just like cooking, there are many appliances that can get the job done. All will produce sustenance, but that steak won’t be very good if you use the microwave, or try to make bread on the grill. The chef needs to know the most efficient way to cook an entree for the best possible result. You’re the head chef of your finances and you’ll want to ensure investments are in the right buckets.
This won’t make you head chef of a fine dining restaurant of finance, but will provide you 10 steps for simple tax avoidance as a DIY investor.
Determine your Investment Allocations
You’re investment allocation is an important factor that will take another letter entirely to explain. For demonstration purposes, let’s walk through an example of 40 Year old “Mr. FIRE” with $500,000 in total investments and the money distributed as follows:
HSA – $20,000
401K – $250,000
IRA – $60,000
Brokerage – $170,000
Step 1 – Define Portfolio Allocation
The first step Mr. FIRE must do is determine his risk tolerance and define an asset allocation. After much research and evaluating his current allocation through Personal Capital, he settles on:
65% US Equities – Take advantage of domestic stock growth.
15% Bonds – Provide some stability and rebalancing opportunities.
10% International Equities – Diversification outside US market.
5% REITS – No home and wants exposure to real estate.
3% Actively Managed Fund – Betting on a manager.
2% Speculative Stock Picks – Gambling on the industry he knows.
Now that Mr. FIRE has identified how he wants his money allocated, he needs to figure out which funds to buy and in what account to place them. The example Funds listed below are for reference only. Your employer sponsored retirement plan may have similar investment options available. In Mr. FIRE’s scenario, we’ll be using popular funds from Fidelity and Vanguard.
Best Funds in an HSA
There’s a couple schools of thought related to what funds should be in an HSA:
- Use the Health Savings Account as another tax advantaged space and invest aggressively in all stocks. This HSA savings strategy is for those that have significant Emergency Funds, are in good health, and can support ongoing costs of medical care from income.
- The HSA is a portion of your Emergency Fund or used routinely for medical expenses. In this case, you’ll want to allocate the investments conservatively. I recommend this option for those with families, older than 40, or with ailments requiring prescriptions and frequent doctor visits.
Step 2 – Allocate HSA Funds
Mr. FIRE opts for the second position due to his age, some routine medication, and supporting the health needs of a family of 4. He wants to keep the $20,000 HSA balance stable even if the market crashes. Mr. FIRE decides to allocate his entire HSA to a U.S. Bond Index Fund with low fees to reduce volatility.
Fidelity U.S. Bond Index Fund Institutional Class (FXSTX)
Best Investments in a 401K or Employer Sponsored Retirement Plan
Your employer sponsored retirement plan could be a 401K, TSP, 403B, etc… This is where you’ll place your least tax efficient investments to take advantage of the tax deferred space. As these plans have limited options, you’ll want to save certain types of funds for a self-directed IRA.
- Target Date Funds – A popular investment choice for the hands off investor. These funds include a bond allocation that produce income taxed as ordinary income outside of a retirement account.
- Bond Funds – Bond funds come in many shapes and sizes and some avoid taxes better than others. The least tax efficient Bonds are high yield corporate bonds followed by treasury bonds and to a much lesser extent municipal bonds. Rather than spending hours reading fine print, it’s much simpler to grab a diversified low cost Bond index fund and just allocate your entire position here. You may have to supplement with holding some in an IRA if the funds aren’t available to meet your allocation percentage.
- Real Estate Investment Trust (REITs) – Taxed as a non-qualified dividend income and thus should be positioned in a tax deferred account.
Step 3 – Bonds in Retirement Account
With this in mind, Mr. FIRE determines he’ll need to allocate the remaining $55,000 of his bond allocation to a position in his 401K plan. He’ll focus on a diversified low cost Bond index fund instead of a Target Date Fund. TDFs are a little more costly than manually setting up your investment and make it difficult to properly balance your asset allocations across various accounts.
Fidelity U.S. Bond Index Fund Institutional Class (FXSTX)
Step 4 –REITs in Retirement Account
Mr. FIRE wants to add some exposure to the real estate market as he does not currently own a home. He allocates 5% or $25,000 to a low cost REIT index.
Fidelity Real Estate Index Fund Premium Class (FSRVX)
Step 5 – Allocate remaining funds in the 401k
With $170,000 remaining to invest in Mr. FIRE’s 401k and allocations met for Bonds and REITS, he decides to place the balance into a Total Market Index Fund for adequate diversification and low fees.
Fidelity Total Market Index Fund Institutional Class (FSKTX)
Keep in mind… when you rebalance a retirement account that use percentages, those numbers are relevant to that account alone and doesn’t take into consideration your other accounts. Your real asset allocation is portfolio-wide. For example, Mr. FIRE would need to put 22% Bonds, 10% REITs, and 68% within the 401K account itself.
Best Funds in a Traditional or Roth IRA
Individual Retirement Accounts are another tax avoidance space for your holdings. Other tax-inefficient investments are REITs, income producing funds, and actively managed funds that frequently churn their holdings.
- Actively Managed, Income, and Growth Funds – Fund managers frequently turnover investment holdings of the fund which pass on the short term and capital gains. Funds containing positions in companies that issue dividends will also produce a taxable event. For these reasons, actively managed funds should be kept in a tax deferred account. Growth funds should be setup in a Roth IRA to take advantage of your highest expected returns and avoid the Required Minimum Distributions.
- Speculative ETFs and Stock Picks – Although speculations are frowned upon, there may be companies or sectors that you are knowledgeable about and feel confident in their potential for success. Speculations should be limited to no more than 5% of your portfolio. This allows you to trade without tax consequences as your assumptions change.
Mr. FIRE has $60,000 in his IRA and has allocated 3% betting on a successful active Fund Manager and 2% in speculations.
Step 6 – Actively Manage Funds in IRA
Mr. FIRE places $15,000 on the fairly successful Fidelity Contrafund to compare its future performance vs an index.
Fidelity Contrafund (FCNTX)
Step 7 –Speculative Investments in IRA
For speculations, Mr. FIRE places $5,000 into the CIBR ETF. He is assuming that the cyber security space is in the beginnings of an extreme growth phase due to recent news articles of many organization suffering from hacks. He also has great hope for Disney’s video streaming service and invests the other 1% into DIS stock.
First Trust NASDAQ Cybersecurity ETF (CIBR)
The Walt Disney Company (DIS)
Step 8 – Allocate remaining funds in the IRA
The remaining $35,000 IRA balance is placed into Vanguard’s Total Market Index Fund for low fees and diversification.
Fidelity Total Market Index Fund Premium Class (FSTVX)
Best Investments in a Brokerage Account
If you have exhausted all tax advantaged space and are still able to contribute to savings, follow the investment priorities methodology. Well Done! You are on the path to building real wealth. This account is subject to income taxes on interest or dividend income and capital gains tax on net asset value appreciation. You’ll want to refrain from trading in this account and rebalance within the retirement accounts as the asset allocation changes over time.
- Total Market Index Funds – Low cost Index Funds should make up the bulk of your portfolio. They passively track a benchmark index and guarantees you average market returns. Only a handful of people have ever beat the index. These funds have extremely low turnover and generates minimal taxable events.
- International Funds – You typically get exposure to international markets through worldwide companies of the total market index. To increase diversification and take advantage in foreign tax credits, you may want to consider a small stake in international equities.
- Municipal bonds – Are ideal if your brokerage account is being used as your emergency fund. Municipal Bond interest is exempt from federal income tax, but earn less than higher yield corporate bonds. if this strategy is of interest, checkout Vanguard’s VWITX or VTEBX. They provide tax avoidance along with stability and diversification.
Mr. FIRE has been depositing money into a Vanguard brokerage account once he reached the annual contribution limits of Fidelity retirement accounts and has accumulated $170,000. He has allocated his Bonds, REITs, Actively Managed Funds, and Speculative investments already. Time to finish up with international and the rest into U.S. Equities.
Step 9 – International Funds in Brokerage Account
Mr. FIRE wants a little more international exposure and decides to put 10% or $50,000 into a low cost Total International Market Index Fund.
Vanguard Total International Stock Index Fund Admiral Shares (VTIAX)
Step 10 – Tax Efficient Index in Brokerage Account
The remaining $120,000 brokerage balance is placed into Vanguard’s Total Market Index Fund to complete his rebalancing effort and reach 65% U.S. equities allocation.
Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
Consider the Tax Consequences of a Rebalance
If you’re just realizing that investments have optimal locations for tax avoidance, you may be stuck with funds in the wrong account. Rebalancing in tax advantaged accounts are no problem, but what if you have a significant bond position in your brokerage account? Firstly, I’m glad you are reading this letter to recognize the mistake. You can do one of two things.
- Stop automatic reinvesting of distributions to the fund and allocate new money to tax efficient funds. You’re accepting the tax consequence of the mistake and adjust overtime.
- Determine the taxes that will have to be paid on the sale. It depends on when the purchase was made and the appreciation of the asset. Bond funds have little tax cost when sold since the returns are mainly from interest. If it makes sense, sell and rebalance
Tax Avoidance is Key
You do not want Uncle Sam or any government to take more than their due. By utilizing these 10 steps, you’ll avoid taxes fairly well as a simple do it yourself investor. Checkout Personal Capital’s Assessment of your portfolio and get started rebalancing before you pay more than you need to.
The tax laws of any country are fairly complex and change frequently. Please seek advice of a tax professional before making any radical changes to your investments.
Please share these tax avoidance strategies and let us know in the comments below how you’d prioritize your investments.
Kylven Ross is the owner and primary contributor of theFIway.com. He has been married for 17 years and is father to a son and daughter living in New England. Professional accomplishments include a bachelor’s degree and industry certifications in the cyber sector. He has spent the last 18 years working in the U.S. Defense Industry and as a Military Police Officer.
He discovered the concept of Financial Independence (FI) during a rather stressful year in the compliance space. After fully absorbing the benefits of FI, he has since committed to turning his household’s finances in the right direction. His experiences are documented as a series of letters that are used to educate his children and others about money. He does not want the next generation to make the same mistakes, but rather achieve financial freedom and find happiness.