Morningstar Advisor - Fall 2008 - (Page 41)

most advisors make to choose an appropriate allocation for each client, this difference may warrant consideration of the effect of location on allocation. Spreads, Time, and Effective Tax Rates Effective Tax Rates Spread Quick Guide to Asset Location Taxable Account The first step in an asset-location strategy is to determine the effective tax rate on each account. Says Chen, “We look at effective tax rates—not your marginal tax rate today, and not the current capital gains rate today. You have to consider when money comes in, when money comes out, and the tax rate over the entire life of the account.” Therefore, time horizon is important. If you’re close to retirement, the effective tax rate is very close to the marginal rate. However, as Chen explains, if you have a 30-year time horizon, the money essentially grows tax-free for 30 years. You are, of course, taxed when the money comes out, but that tax can be thought of as having been “spread out” over the 30-year period. The longer the time horizon, the lower the effective tax rate. The thing to look for is the spread of the effective tax rates between both account types and different investment vehicles. That is, the tax efficiency of the underlying investment makes a huge difference. A static ETF portfolio and the portfolio of an actively managed mutual fund, for example, might be equal from an asset-class standpoint, but they’re entirely different animals when it comes to tax efficiency. “You want to look at the effective tax rates on different investments, not asset classes,” Chen says. The goal is to find the ones with the biggest spread and—as much as possible— take full advantage of those spreads. And that’s what the Ibbotson optimization engine does. Working from a desired asset allocation and a proposed security lineup, it seeks to maximize the spread, as displayed in this graph, which shows the effective tax rate over time of hypothetical securities in taxable (red line) and nontaxable account types. Effective Tax Rate This list, taken from Bill Reichenstein’s In the Presence of Taxes: Application of After-Tax Asset Valuation, prioritizes the assets that should be held in tax-deferred and taxable accounts. Tax-Deferred Account Time Horizon Most advisors, however, probably aren’t using an optimizer to make their location decisions. Plant says that it’s “more art than science.” He and Harroz say that they make their location choices at the individual client level. Harroz says that it’s difficult to use a cookiecutter approach, as each client situation is unique. For example, some of the advantages of tax-deferred accounts are lost on those clients who remain in the highest tax bracket their entire life, because they never have the opportunity to make withdrawals at the lower rate. The Real World: The Man, Liquidity Needs, and Losses Best assets to hold in tax-deferred accounts and tax-exempt Roths: r Bonds (defined broadly to include all interestbearing assets like CDs). r estate investment trusts. Real r Hedge funds. r Tax-inefficient stock funds such as active funds that realize substantial short-term capital gains. Best assets to hold in taxable accounts: r Stocks or any other asset whose returns will accrue as capital gains and that the individual will let grow unharvested for long horizons. This may include stock index funds, tax-managed stock funds, tax-efficient ETFs, individual stocks, and undeveloped real estate. When it comes to actual location of client assets, there’s always going to be a difference between the “ideal” location and what’s possible in the real world. Harroz thinks of it in terms of three limiting parameters. The first is “the rules the federal government puts in place.” That is, in addition to setting tax rates, there’s the issue of the limits as to how much money can be held within—or transferred to— certain tax-deferred accounts. The second factor is client disclosure. If a client isn’t completely forthcoming about all of his or her assets, including those not managed by the advisor, it’s difficult to create the optimal location. The third item on Harroz’s list is “perfect information about what the future will be,” which obviously no advisor has. While both stressed the importance of asset location, Reichenstein and Chen also had a full lists of caveats to consider when locating client assets. First, unless your client’s primary goal is “sticking it to the man” and avoiding taxes on principle, it’s important to remember that the goal is to maximize aftertax income, not minimize the payment of taxes. Although the two concepts go hand in hand, it’s certainly possible for them to diverge. That is, it’s better to pay 25% in taxes on a 20% gain than it is to pay zero taxes on a 10% gain. Another consideration is that what matters most is minimizing taxes over an investor’s lifetime. Plant explains that although it might make the typical CPA cringe, sometimes it’s better to pay additional taxes one year in order to minimize the lifetime tax burden. For example, if a client’s marginal tax bracket MorningstarAdvisor.com 41 http://www.MorningstarAdvisor.com

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Morningstar Advisor - Fall 2008 Contents New on MorningstarAdvisor.com Letter from the Editor Contributors Inbox Are You Preparing for Higher Taxes? State of Financials Oracles of Alabama Investment Briefs Managers’ Investment Secrets Revealed Conformity Becomes a Growing Concern at American Gimme Shelter Location, Location, Location Rooted in Buffett, Going for Growth Keeping Little Company Away from the Numbers Consumer Confidence What about Natural Gas? TIPS to Beat Back Inflation Investing in Hidden Assets Funds That Have an Edge Come Tax Time Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar One for You, 19 for Me

Morningstar Advisor - Fall 2008

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