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Position Optimization – Tax Alpha

Jan 25, 2024

Allocating Across Traditional IRA, Roth IRA, and Nonqualified Accounts for Higher After-Tax Returns

Achieving higher after-tax returns, both over your clients’ lifetimes and for subsequent generations, is the main goal of most portfolio strategies. However, while most advisors spend a great deal of time and energy determining the mix of assets and securities that their clients will invest in, many are overlooking another tool for maximizing returns: position optimization. Position optimization strategies take into account the tax characteristics of three types of investment accounts — traditional IRAs, Roth IRAs, and non-qualified accounts — in allocating assets.

All three of these account types have unique tax attributes that can affect wealth accumulation over time.

  • In traditional IRAs, for instance, investment gains accrue tax-deferred, but ordinary income tax is due when assets are withdrawn. After age 70.5, owners of traditional IRAs must make required minimum distributions representing a certain percentage of IRA assets.
  • Roth IRAs grow tax-free and withdrawals are tax-free.
  • And finally, non-qualified accounts generate dividend and interest income continually, but capital gains need not be realized until the assets are sold.

If the account owner dies without selling assets in a non-qualified account, the cost basis for his or her heirs is “stepped up” to the value at the time of the owner’s death. A position optimization strategy looks at an investor’s portfolio at the household level, that is, across all three types of accounts. It allocates higher growth assets like stocks into accounts with potential tax-free growth (Roth IRAs and non-qualified accounts through stepped-up basis) while keeping lower growth assets (bonds, etc..) in the traditional IRA portion of the portfolio.

To see how position optimization works, let’s look at a hypothetical $1 million portfolio with a target allocation of 50% stocks and 50% bonds. The investor holds $500,000 in a traditional IRA and $250,000 each in a Roth IRA and non-qualified accounts. We’ll assume average annual returns of 3% in the bond portion of the portfolio and 7% in stocks.

Without Optimization

In a non-optimized approach, the advisor would invest each of these three accounts in a 50% stock/50% bond mix. Over 10 years, the $500k IRA grows at a 5% average return to $814,447.31. But when the owner dies, beneficiaries will pay an average combined Federal and State tax bracket of 25%, so their inheritance, after-tax, is only $610,835 The $250,000 Roth IRA also earns a 5 % average annual return. It grows to $407,223, which passes to beneficiaries tax-free. The $250,000 non-qualified account earns the same 5% and grows to the same amount, $407,223. Beneficiaries inherit this amount tax-free and their cost-basis is stepped up to $407,223. The account’s total after-tax value is $1,425,281

With Optimization

Now let’s look at what happens when the advisor allocates the entire $500,000 traditional IRA to bonds and both the Roth IRA and non-qualified accounts to stocks. The traditional IRA earns 3% a year on its 100% fixed income allocation, after 10 years growing to $671,958. As before, the owner’s heirs must pay an average combined Federal and State tax liability of 25%, so their after-tax balance is $503,968. The Roth IRA earns a 7% annual return over 10 years, increasing the original $250,000 investment to $491,787. This amount can be passed tax-free to beneficiaries. The same is true of the non-qualified account, which also grows to $491,787.

The total portfolio, after taxes, is worth $1,655,532 after ten years. That’s $230,251 more than the same portfolio without position optimization — an increase in an average annual return of 1.51% without any additional risk.

Over longer periods, your clients and their heirs will reap even larger rewards. For 20 years, using the same approach, the optimized portfolio outperforms by more than $500,000 after taxes. Over 30 years, the gap is nearly $1 million. For simplicity’s sake, we’ve looked at portfolios comprised only of stocks and bonds. However, in theory, this approach could incorporate alternative assets like venture capital, private equity, and hedge funds in the Roth IRA and non-qualified portion of the portfolio, and other forms of fixed income (emerging markets, high yield, private placements, and cash) in the traditional IRA portion.

Additional Benefits

A position optimization strategy also reduces transaction costs, since portfolio positions are larger and less spread out over multiple accounts. For instance, take the first non-optimized portfolio where all three accounts – traditional IRA, Roth IRA, and non-qualified – are split 50% equity/50% fixed income. Now consider that the 50/50 allocation might be implemented by a model using 15 different ETFs. To invest in the portfolio, then, the advisor has to buy 15 ETFs for each of the three portfolios or 45 transactions; every time he rebalances, he will trade 45 positions. The position-optimized approach cuts down transactions by two-thirds. That can result in significantly higher returns over time, since ETF transactions typically cost around 1% of asset value. A final benefit comes during the withdrawal phase, when investors must begin taking required minimum distributions from their traditional IRA accounts. Because these accounts are invested in fixed-income assets, investors don’t have to worry about being forced to withdraw money when prices are temporarily depressed. They also benefit, long-term, from withdrawing lower-returning assets now, while leaving higher return potential assets in place to appreciate further.

Transitioning to a Position Optimization Strategy

Moving clients into a position optimization strategy is straightforward since both traditional and Roth IRA assets can be reallocated without tax consequences. One difficulty can emerge if the client holds assets with large embedded capital gains in a non-qualified account. In that situation, the best strategy is to retain those positions and build a strategy around them. If some or all of the appreciated securities must be sold, we typically do it gradually, offsetting gains where possible with offsetting capital losses.

A position optimization strategy can work for almost any size account, from relatively modest to multiple millions. The benefits are greatest for clients who do not expect to exhaust their assets during their lifetimes, because of the tax advantages for heirs. However, even families who will use most of their savings in retirement can benefit.