Asset Location and Other Investment Portfolio Tax Considerations

The traditional goal in building portfolios, as described in Modern Portfolio Theory, is to maximize return for a given level of risk, but this only provides part of the picture for an individual investor. Managing tax efficiency also plays a major role, as improving after-tax returns increases the amount available to spend from an investment portfolio. At the end of the day, as the saying goes, “It’s not what you make, but what you keep” that matters most. This article addresses a variety of tax considerations in portfolio construction, such as the asset location of traditional investments, a strategy for investors with significant tax losses from tax loss harvesting, and an overview of the tax treatment of alternative investments.

As an individual investor, you have the opportunity to optimize your after-tax return by leveraging three different types of investment accounts: taxable (or brokerage) accounts, tax-deferred accounts (e.g., a pre-tax IRA or 401(k)), and tax-exempt accounts (e.g., a Roth IRA or Roth 401(k)). Utilizing an asset location strategy is a powerful tool that allows you to treat all account types in a household as one portfolio, thereby minimizing the tax cost of holding a given investment portfolio. 

The following is a high-level prioritization by account type for tax location purposes:

• Tax-Exempt Accounts (Roth IRA/401K Accounts)
  • These accounts are not subject to tax upon withdrawal, assuming withdrawals occur after 59.5 and the account has been open for at least five years.
  • Emphasize tax-inefficient investments with the highest expected returns. This could include equity funds with high turnover or less efficient segments of the global equity market (e.g., emerging market equities).
• Tax-Deferred Accounts (Pre-Tax and After-Tax IRA/401K Accounts)
  • These accounts are subject to ordinary income tax upon withdrawal and are subject to penalties if withdrawn before age 59.5 unless certain exceptions are met.
  • Emphasize tax-inefficient investments with lower returns than those placed in Roth. This often could include fixed-income strategies or lower expected return high-yielding segments of the equity market, such as utilities.
• Taxable Accounts
  • The tax treatment is characterized by the investments held (capital gains, interest income, dividend income) and subject to tax each year. 
  • After prioritizing tax-inefficient investments that can be placed in retirement accounts, allocate the remainder of the portfolio to the taxable account. The balance of the taxable account relative to the retirement accounts will also play a role in determining tax efficiency, as the higher the relative space available in retirement accounts, the higher the level of control that will be available to the investor.
  • Important note: If seeking liquidity prior to the age when penalty-free withdrawals can be made from retirement accounts, an investor may want to prioritize less tax-efficient investments such as bonds in taxable accounts. This could be due to the potential for a major purchase or early retirement.

Fixed Income Asset Location

The tax treatment of bonds can get complex, but the key points are as follows:

• The expected return and tax cost for a bond held to maturity are based on the current yield and tax characterization.
• There are exceptions, but typically, municipal bonds are not subject to Federal income tax.
• In-state municipal bonds are exempt from Federal, state, and local taxes.
• Treasury bonds are generally exempt from state and local taxes but subject to Federal tax.
• Corporate Bonds, CDs, and other types of bonds are typically fully taxable at the Federal, state, and local levels.

The following pre-tax yield would be required to net 3% after-tax to an NYC taxpayer¹ with $1M taxable income (regardless of filing status):

• 3% NYC Municipal Bond
• 3.36% Out of State Municipal Bond
• 5.07% US Treasury Bond
• 6.19% Corporate Bond, CD, or Savings Account 

Emphasizing fixed income in retirement accounts often makes sense, given that you could place the highest yield bonds without considering current-year taxation (tax-free municipal bonds are almost always significantly lower yielding than taxable bonds due to their preferential tax treatment). That said, the time horizon for the use of funds is also important. For example, suppose an investor is in their 30s and looking to fund a significant purchase in 3-5 years. In that case, you may prioritize holding fixed income in a taxable account to better match the risk of that account with the time horizon for reaching a given goal. 

Equity Asset Location

To better quantify the tax efficiency of various equity ETFs and mutual funds, we gathered data on historical dividends, the proportion of qualified (long-term capital gains tax rates) vs. non-qualified dividends (ordinary income tax rates), 199A dividends (20% QBI deduction), and foreign tax credits where applicable. This data collection is crucial in understanding the tax implications of these investment options.  

As a secondary factor for ETFs with similar tax costs, ETFs with higher expected volatility provide increased potential for tax loss harvesting. Conversely, low-volatility assets are less likely to offer this opportunity.

The following shows data for an NYC taxpayer with $1M taxable income that would be taxed on the next dollar earned from distributions on the following list of funds. (All filing status would have the same marginal tax rates based on the current brackets for Federal, NY, and NYC):

An investor could hold the index’s underlying sectors tax-efficiently further to optimize the tax efficiency of S&P 500 holdings. 

When constructing the portfolio, it’s usually best to emphasize low tax efficiency and high expected return assets in Roth. Examples from the above include DFA Emerging Market Small Cap (DEMSX), XLRE, and XLE. Since utilities are traditionally considered lower expected return equities, it could make sense to emphasize this holding in a pre-tax retirement account. However, this also depends on the relative balances across each account type.

Tax Efficiency with Significant Realized Capital Losses

When a taxpayer has significant tax losses, options-based strategies can be employed to increase tax efficiency further. Utilizing exchange-listed index options subject to marked-to-market 1256 treatment (60% long-term and 40% short-term) can create a broad array of exposures, typically subject to capital gains tax treatment with no dividends or interest paid.

The following is an example scenario (pre and post-tax) of three portfolios (based on 07/16/24 at 2:20 PM ET data):

• Scenario 1: ~25.5% S&P 500 ETF and ~74.5% 1 Year Treasury Bond
• Scenario 2: ~25.5% S&P 500 ETF and ~74.5% New York Muni Bond ETF (NYF) assuming expected return equal to yield
• Scenario 3: Synthetic options portfolio replicating ~25.5% S&P 500 and ~74.5% 1 year-bond

Assumptions Used for All Scenarios (based on data obtained on 7/16/24 at 2:20 PM ET)

• Initial Portfolio Value $2,218,709
• S&P 500 Index Level (SPX): $5,652.16
• S&P 500 Dividend Yield: 1.21%
• Initial Exposure to the S&P 500 Index in each Portfolio: $565,216 (Initial Index Level x 100)
• Initial Allocation: 74.5% Bonds and 25.5% S&P 500
• Treasury Bond Yield (1-Year): 4.90%
• iShares New York Muni Bond ETF Yield (NYF): 3.22%
• Synthetic option assumptions based on the chart below:

Scenario 1 – 1-Year Treasury Bond and S&P 500 ETF

Scenario 2 – New York Muni ETF (assuming return equivalent to current yield) and S&P 500 ETF

Scenario 3 – Synthetic Balanced Portfolio

• In this scenario, we assume the investor has significant tax losses that fully offset the gains from the S&P 500 (SPX) index options positions shown.
• 1-Year Bond Synthetic Exposure: $1,653,493 position purchasing 2 of the $200 Strike Call + $9,000 Strike Put Combinations
• S&P 500 Exposure: Long $565,216 of S&P 500 Index by purchasing 1 additional $200 Strike Call to obtain similar exposure to the first two scenarios
• Total position: Long 3 SPX $200 Strike Call Options + Long 2 $9,000 Strike Put Options (both expiring 7/17/25)

Data below was obtained on 7/16/24 at 2:20 PM ET.

S&P 500 Index Level (SPX): $5,652.16

Comparison of Scenarios

As you can see from the chart above, the pre-tax returns of the balanced portfolio with Treasuries and an S&P 500 ETF position are quite similar to those of the options replication portfolio. However, the tax savings are meaningful when sufficient tax losses are available to offset the capital gain generated from the options positions.

Risk of Utilizing Options

• Options strategies are generally considered a strategy for investment professionals due to the complexity involved in implementation.
• Brokers typically require option approval to implement these strategies. Trading and execution errors could result in significant losses.
• The examples provided do not include the impact of fees, commissions, and execution at undesirable prices.
• Exiting the position before maturity could result in losses due to execution, liquidity, and an increase in interest rates, among other factors.           
• Investors should consult their tax advisors to determine how the profit and loss on any particular option strategy will be taxed. Tax laws and regulations may be complex, may change, and can be subject to interpretation.

Tax Considerations for Alternative Investments

The tax treatment of alternative investments is relatively complex and will depend on the strategy and the investment vehicle. 

For example, a Registered Investment Company (“RIC”) such as a mutual fund or ETF, typically deducts fund expenses against the income the fund generates. Hedge funds structured as a limited partnership or LLC typically will pass through income and expenses separately on a K-1 to shareholders. While a performance allocation (such as the traditional 20% performance) is still effectively deductible, many expenses (including management and administrative fees) are not under current tax law. 

The following examples demonstrate the tax impact, assuming a 10% return to the investor (net of 3% expenses that cannot be deducted for tax purposes) for an NYC-based investor with $1M of other income:

Private Credit Fund (Mutual Fund)

• 10% Net Pre-Tax Return
• -5.15% Tax Cost Assuming 100% Ordinary Income
• 4.85% After-Tax Return

Private Credit Fund (LP/LLC)

• 10% Net Pre-Tax Return
• 3% Add back non-deductible expenses
• 13% Taxable Income
• -6.70% Tax Cost Assuming 100% Ordinary Income
• 3.3% After-Tax Return
• Note: If the private credit fund had any loans default, these would pass through as capital losses, which do not offset the ordinary income generated by loans that are paying, further increasing the tax cost.

Private Equity Fund (RIC)

• 10% Net Pre-Tax Return
• -3.45% Tax Cost Assuming 100% Long-Term Capital Gains
• 6.55% After-Tax Return

Private Equity Fund (LP/LLC)

• 10% Net Pre-Tax Return
• 3% Add back non-deductible expenses
• 13% Taxable Income
• -4.49% Tax Cost Assuming 100% Long-Term Capital Gains
• 5.51% After-Tax Return

Private Equity Fund (RIC or LP/LLC) with Harvested Tax Losses Offsetting Gains

• 10% Net Pre-Tax Return
• 10% After-Tax Return
• The offset gain reduces capital loss carryforward

Active Trading Strategy (Mutual Fund) or an LP/LLC with “Trader Status”

• 10% Net Pre-Tax Return
• -5.15% Tax Cost Assuming 100% Short-Term Gains
• 4.85% After-Tax Return
• Note regarding “Trader Status”: An LP or LLC with trader status will allow investors to fully deduct all expenses, assuming the fund has sufficient activity to qualify. A fund with “Trader Status” may also make a Section 475 election, which is an election to treat gains and losses as marked-to-market ordinary income instead of capital losses.

Active Trading Strategy (Mutual Fund) or an LP/LLC without “Trader Status”

• 10% Net Pre-Tax Return
• 3% Add back non-deductible expenses
• 13% Taxable Income
• -6.70% Tax Cost Assuming 100% Short-Term Capital Gains
• 3.3% After-Tax Return

Active Trading Strategy (Mutual Fund) or an LP/LLC and Harvested Tax Losses Offsetting Gains

• 10% Net Pre-Tax Return
• 10% After-Tax Return
• The offset gain reduces capital loss carryforward.
• If a “Trader Status” fund makes the Section 475 marked-to-market ordinary income election, harvested tax losses would not offset gains from the fund. 

Placing alternatives in a tax-advantaged account

Given the tax impacts illustrated in the prior examples, it can be quite appealing to utilize a Traditional or Roth IRA to make these investments, particularly those that generate ordinary income, such as private credit funds. That said, there is another type of tax on retirement vehicles, known as Unrelated  Business Income Tax (“UBIT), which can be triggered when investing through passthrough entities such as an LLC or LP that borrow funds to invest or operate businesses. This is a complex topic beyond the scope of this article.

As detailed above, optimizing a portfolio for tax considerations can involve some complexity, but the impact can be meaningful. In addition to the abovementioned strategies, tax loss harvesting and direct indexing strategies can help generate tax losses, improve after-tax outcomes, and complement the strategy mentioned. While this primer is a good starting point for understanding optimizing portfolio tax efficiency, several other investment tax characteristics are beyond this article’s scope, including but not limited to real estate and oil and gas investments.

Footnotes

¹A NYC taxpayer with $1M of taxable income will have the following marginal tax rates

• 37% Federal Income Tax
• 20% Federal Capital Gain Tax
• 3.80% Net Investment Income Tax (NIIT)
• 6.85% NY Income Tax
• 3.88% NYC Income Tax

²For the DFA ETFs listed with a history of less than five years, we utilized mutual fund tax data but removed the tax impact of any mutual fund capital gain distributions. This adjustment was made to operate under the assumption that the ETF in-kind creation and redemption feature of ETFs facilitated by authorized participants would prevent capital gains distributions.

³Tax-Cost of Treasury Position: 4.9% yield * 74.5% weight * 40.8% tax rate (highest Federal marginal tax rate): 1.49%

⁴Calculated utilizing the average tax cost over the past five years for a NYC-based taxpayer with $1,000,000 of income prior to the investment income. 

⁵Halfway point between the midpoint and ask on options quote shown.

Article Post Disclaimer

Astra Wealth Partners LLC is a registered investment adviser registered with the United States Securities and Exchange Commission.

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