Tax efficient asset allocation

Over at Reddit we came across the following discussion, "Tax efficient asset allocation":

I understand the concept but how does one actually go about implementing it? Specifically, how do I do it? I'm in my mid-40s with >$1.5 million net worth. Of this, the tax sheltered portion includes $261K in a 403b (TSP), $156K in a 401k, $123K in my Roth, $117K in my wife's Roth, $33K in 529 plan, and $37K in a life insurance annuity. Outside of this I have about $825K invested in taxable investment accounts.

In order to move assets around according to basic principles of tax efficient allocation at this point, I imagine would trigger a six figure capital gain in the process. I can't imagine that the benefit of tax efficient allocation would offset this major tax hit right now. Am I missing something or at this point am I best off just continuing as I have been doing (allocating according to my risk tolerance and timeline but not paying attention to tax advantaged vs taxable accounts)?

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[–] aBoglehead 6(6/0) 16 hours ago

I can't imagine that the benefit of tax efficient allocation would offset this major tax hit right now.

In your case it's probably not worth it. You might be able to do a little bit of rearranging (if you want to, and transaction costs are sufficiently low) by selling off only those lots that have a capital loss or very small capital gains. However, if the majority of your shares have gained value then it's best to simply keep investing according to your asset allocation,keeping tax efficiency in mind going forward.

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[–] lightcloud5 5(5/0) 17 hours ago

Admittedly, it can be difficult to move existing assets around (since doing so would trigger capital gains).

Though, at least, you could allocate new investments in accordance with the principles of tax-efficient allocation.

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[–] harruin 4(4/0) 16 hours ago

In your case, you consider the tax efficient allocation on future contributions.

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[–] wijwijwij 4(4/0) 11 hours ago * (lasted edited 10 hours ago)

Doing a major readjustment that would trigger a six figure capital gain would seem to be unwise, because that would result in a five-figure cap gain tax amount that could be difficult to come up with in one year. But I don't think you need to entirely give up and only direct future contributions in tax-efficient ways.

I'll tell you what I did a few years ago to reposition some of my asset classes. This may not apply specifically in your case, but it may at least suggest avenues to pursue.

First off, identify what the problem is that you're trying to solve by adjusting your asset location. In my case, I had my 401k entirely invested in stock index funds, and I had bond index fund holdings in a taxable account. I realized after several years that the bond index funds in that location had a significant enough amount of dividends that I was paying taxes on each year. The problem was that I didn't think about that earlier when I was setting up my 401k contributions.

I could have partially "solved" the problem just by making new contributions in my 401k to a bond fund, and not making any new purchases in my bond fund in taxable account. But I really didn't think it was maximally tax-efficient to keep the bond fund in that taxable location.

Next, I identified a procedure to address the problem. It was not an issue to adjust my 401k balance to include a low-cost bond fund. So I knew that once I got rid of bonds in my taxable account, I had plenty of leeway to have an equivalent amount in my 401k. The issue was that selling my bond index fund would incur gains.

In my case, liquidating my entire bond index fund led to cap gains of $14,600. That's a five-figure amount, not a six-figure amount, but still was a lot to me. If I had simply done that, I would have owed cap gains tax on that amount. Probably something like $2190 more in taxes than I expected.

Instead, I offset this with some strategic sales of stock index funds where I knew I had losses. This is an example of tax-loss harvesting. In order to have losses to offset the gain from the bond sales, I used "specific identification" method for choosing which past shares I had bought in one of my stock index funds. I ended up identifying 7 lots (specific purchases on specific dates). This was back before the cost basis record-keeping rules changed. Since I hold my taxable stuff at Vanguard, I had to communicate before the sale via electronic message and then follow up with them via mail to communicate the shares I was intending on selling. They sent me back a confirmation letter (much later) basically repeating what I had told them. (Nowadays, for "covered shares" purchased more recently, Vanguard has mechanisms in place for doing this more smoothly, I trust. But for "noncovered shares" it is still a bit of a pain to explicitly use the specific share id method.)

By selling so I had a loss of $16,900, I was able to offset the gain of $14,600, ending up with a net loss of $2,300 that was under the $3000 loss threshold allowable. This was reported using Schedule D.

After this was done, I had my records backing up my specific share ID, which I need to keep. Also, the cost basis figures that Vanguard gives me, which are based on average cost, are meaningless now for this particular fund, because my new cost basis is my old cost basis minus the cost basis of the particular shares I sold. So I have to keep track of that myself.

I then did an exchange in my 401k so some of my funds there became invested in exactly the same bond fund I had sold at a gain from my taxable account, since my 401k actually offered it. (Note: There is no wash-sale rule to worry about for buying a fund that you sold at a gain. However, there is a wash-sale rule to worry about when you do tax-loss harvesting. In my case, I had to make sure not to rebuy the stock index fund I sold shares at a loss from for a certain period of time. So, I actually had to turn off automatic reinvestment of dividends for that fund!)

The result was I got my bond fund into my tax-advantaged space, without incurring an onerous tax bill. It just requires a little extra record-keeping to maintain the specific share id information related to the stock fund that I did tax-loss harvesting from.

I'm not sure if you're willing to look at using losses to offset gains in this specific way, or even whether the amount of gains you seem to expect could be offset by losses. But it may be worth at least seeing if harvesting losses might at least do something to moderate the capital gain to a manageable tax amount.

One additional benefit to this, for me, was that it has now meant that I have fewer dividends to pay taxes on each year. This has turned out to be useful this past year, when I stopped working and wanted to keep my income in a very low bracket for purposes of Obamacare. If I still had my bond fund where it was, I suspect the unearned income they produce could very likely tip me into a place where I wouldn't get credits for premiums. This isn't why I did it in the first place but has been a good consequence.

Another idea, I suppose, might be to wait until such time as you may fall into a 10% or 15% bracket, if you ever think that could be the case in early retirement. During those years, you could reposition taxable funds into tax-advantaged more easily when the amounts you sell generate gains that have 0% cap gains rate, i.e. they keep your income within the 15% bracket. But from the figures you gave in OP and the fact that you're only in your 40s, I suspect perhaps even this is unlikely, as you have quite a nest egg built up.

I do think it's worth giving this topic some thought, rather than immediately concluding that what you currently have as asset location is something you have to live with. Certainly adjusting future contributions to stop doing inefficient location is a good idea, but don't rule out doing some selling in your taxable account if you can do it in a way that isn't too costly. (You might have to think about this across a couple of years, so you don't jump into an even higher tax bracket that could increase cap gains tax rate even higher than it is for you now.)