Sponsors Insights: Can Strategic Asset Location Lessen The Impact Of Tax Friction?

Key points:

Tax friction — also known as tax cost ratio — is the difference between an investor’s pretax and after-tax returns, or the amount of annualized return lost due to taxes from net realized capital gains and other taxable income, like dividends from stocks or interest from bonds. Though it is often represented as a small percentage, its long-term effects can be substantial.

 

For example, a 1.5% annual tax friction on a $1 million investment over 10 years can result in over $250,000 in wealth erosion. The more wealth a client accumulates over time, the more they stand to lose without a proactive approach to managing tax friction.

 

Strategic vehicle selection, like the use of separately managed accounts, and optimizing asset allocations are two ways to help mitigate the tax bite on client returns. However, the most effective method is proper asset location —strategically placing different investments in optimal accounts to help maximize tax efficiency.

 

Traditional asset location approaches may fall short

A common approach to asset location is to separate tax efficient investments (stocks, for example) and place them in taxable accounts while placing tax-inefficient assets (such as bonds) in tax-deferred accounts. While it is a step forward from having no asset location strategy at all — simply mixing stocks and bonds in accounts aimlessly — it unfortunately may fall short of what should be a more methodical and holistic strategy. 

 

A better approach is to consider the relative tax-efficiency of an asset class as well as its future return potential, strategically placing investments across three account types: taxable (like a non-qualified brokerage account), tax-deferred (such as a 401(k) or an IRA) and tax-free (a Roth IRA).

 

For example, large-cap and small-cap stocks have had similar levels of tax friction as returns tend to be taxed at capital gain rates. However, with small caps currently expected to outperform large caps, small caps could be better suited for a tax-free account, allowing investors to keep more of their potential excess returns since future withdrawals could be free from taxes.

 

Similarly, returns from high-yield bonds and investment-grade corporate bonds are often taxed as ordinary income. By placing high-yield bonds in a tax-free account rather than a tax-deferred account, investors could benefit from the higher expected returns without the resulting larger tax consequences upon withdrawal.

It’s critical to consider an asset location strategy that combines asset class tax efficiency with its historical or expected returns, as relying on just one aspect may not provide the full picture. For example, you’ll notice above that U.S. large cap stocks have had a relatively high tax friction over the last 10 years, which is largely due to above average annual returns of 11.21%,1 for an otherwise fairly tax-efficient asset class. However, when you combine asset class tax-efficiency with lower expected returns, placing U.S. large-cap stocks in a taxable account may be warranted.

 

Effective tax-efficient investing requires a methodical, holistic asset location strategy that goes beyond the traditional approaches, which may help your clients achieve greater after-tax returns year after year.

 

Help ease the impact of investment-related taxes with additional ideas and resources by visiting: Practice Management Insights > Tax-efficiency or contact your regional advisor consultant at 800.426.3750.

 

 

 

 

 

1 Source: Lipper. 10-year average returns represented by Lipper mutual fund category U.S. Large Cap as of 06/30/24. The views expressed in this material are the views of Columbia Threadneedle Investments through the period ended September 30, 2024 and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be appropriate for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.

Forecasted five-year returns vs. 10-year average tax-friction chart disclosures: Equity forecasts are based on three components: expected dividend payments, expected earnings growth and change in valuation levels (price-to-earnings ratios). Expected earnings growth is driven by expected economic growth, input cost changes and pricing power. Fixed-income forecasts are based on the shape of the yield curve, direction of interest rates, increase/decrease in yield spreads and timing of those changes. The major asset classes represented are based on the following indices and Lipper categories, respectively: U.S. large-cap stocks (S&P 500 Index and Large-Cap Core Funds), U.S. small-cap stocks (Russell 2000 Index and Small-Cap Core Funds), Developed market stocks USD (MSCI EAFE Index and International Large-Cap Core), Emerging market stocks USD (MSCI EM Index and Emerging Markets Funds), U.S. Treasuries (Bloomberg U.S. Treasury Index and General U.S. Treasury Funds), Municipal Bonds (Bloomberg Municipal Bond Index and Intermediate Municipal Debt Funds), Investment-grade corporate bonds (Bloomberg U.S. Aggregate Credit Index and Core Bond Funds), High-yield corporate bonds (Bloomberg Corporate High Yield Index and High Yield Funds), Absolute return (FTSE U.S. Domestic 3-Month T-Bill Index), Commodities (Bloomberg Commodity Index).

The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. The MSCI Europe, Australasia, Far East (EAFE) Index is a capitalization-weighted index that tracks the total return of common stocks in 21 developed-market countries within Europe, Australasia and the Far East. The Bloomberg Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. The JPMorgan Emerging Markets Bond Index Global (“EMBI Global”) tracks total returns for traded external debt instruments in the emerging markets and is an expanded version of the JPMorgan EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. It covers more of the eligible instruments than the EMBI+ by relaxing somewhat the strict EMBI+ limits on secondary market trading liquidity. FTSE U.S. Domestic 3-Month T-Bill Index: FTSE 3-Month Treasury Bill Index is an unmanaged index that tracks short-term U.S. government debt instruments. Bloomberg U.S. Treasury Index: Bloomberg US Treasury Index represents the US Treasury component of the US Government index. Bloomberg Corporate High Yield Index: The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded. The Bloomberg Commodity Index Total Return (formerly DJ UBS Commodity Index), is a broadly diversified index composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME). It is not possible to invest directly in an index. Indices are unmanaged and not available for direct investment. Diversification does not assure a profit or protect against loss.

Columbia Threadneedle Investments and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.