In Part I of our series on Tax-Wise Investing, “You and Your Investments,” we explored how to engage in year-round tax-wise investing by adopting your own best practices as well as by favoring fund managers who are likewise keeping a tax-efficient eye on their offerings. There are two other important areas to tend to as part of your due diligence: your investment portfolio’s tax-efficient management and your advisers’ tax-efficient teamwork.
Proper Portfolio Management: The Art of Asset Location
Beyond tax-wise management of the individual funds in which you’re invested, some categories of investments are inherently more tax-efficient than others. For example, stock funds are usually more tax-efficient than bond funds (with many caveats that we won’t go into here). A plain vanilla U.S. stock fund tends to be more tax-efficient than funds seeking to capture the expected premium returns from smaller, less liquid markets. And so on.
This means that another vital way to manage your taxable income is to practice wise asset location, which is a fancy way of saying that you should place the least tax-efficient funds within your tax-sheltered retirement accounts, where the inefficiencies are more effectively rendered moot. The reverse is true for your most tax-efficient holdings. You want to keep them out of your tax-sheltered accounts, where their tax-efficient advantages are often lost.
The concept is simple enough, but implementation can be tricky. First, there is only so much room in your tax-sheltered accounts. Challenging trade-offs must be made to ensure you’re making best use of your available tax-sheltered “space.” Effective asset location also involves considering other tax-planning needs, such as the ability to harvest capital losses against capital gains, donate appreciated shares to charity, implement a step-up in basis, and take foreign tax credits. While these opportunities have more or less importance depending on your goals and circumstances, they become unavailable for stocks held in tax-sheltered accounts.
In short, arriving at – and maintaining – the best asset location formula for you and your unique circumstances is something of an art as well as a science. That’s one reason why it’s important to have a well-coordinated adviser team, to ensure that you’re making best use of all of the wealth-building opportunities available to you, including but not limited to asset location.
Organized Alliances: Do Your Advisers Get Along?
It’s important to manage your investments tax efficiently. But what about when it comes time to transfer your wealth – bequeathing it to heirs and making meaningful donations? And what about your tax filings themselves? Is your accountant aware of what your investment manager is up to, and are both of them informed of pertinent details related to your estate planning?
In short, are key members of your financial team – your estate planning attorney, investment adviser, tax professional, insurance providers and others – acting in isolation or in coordinated concert with one another? Even if each is seeking to best manage tax-related events within his or her specialized area of expertise, if there is little or no coordination among their activities, unnecessary (taxable) gaps or overlaps may occur when key communications break down.
Putting It Together: The Tax-Wise Wealth Manager
Tax-efficient investing can add considerable power to your net wealth – the kind you and your family get to keep after taxes and expenses have taken their toll. But making the most of the many opportunities can be daunting if you’re going it alone. As we’ve covered in this series, tax-wise investing includes:
• Establishing an effective Investment Policy Statement
• Making best use of available tax-sheltered or tax-free investment accounts
• Investing tax efficiently yourself
• Selecting fund managers who invest tax efficiently on your behalf
• Appropriately locating your more and less tax-efficient holdings among your taxable and tax-favored accounts
• Ensuring that all of the members of your financial team are acting in tax-efficient concert with one another across the spectrum of your financial activities
All this and more is why the final piece in the puzzle is to engage a wealth manager like J. F. Williams Co., Inc. to organize the many moving parts and players involved, keep an eye on it all over time, and help you and your specialized team members make adjustments when appropriate. The savings achieved can more than offset your investment in ongoing oversight of your tax-wise wealth. That’s a good idea, any time of the year.