Challenging the Status Quo

We get puzzled looks from new clients when we explain our position on taxable fixed income (bonds) in IRAs. Traditional planning advice recommends placing your highest growth assets in an IRA to maximize the tax deferral. We usually recommend the complete opposite approach, which becomes more and more preferable the higher the income of the current or future retiree.

We prefer to aggregate investor bond exposure in IRAs since taxable bonds produce income that incurs the most punitive form of tax, ordinary income. Holding taxable bonds in personal or joint accounts would only spread the contagion of high-tax items. We prefer to align all forms of punitive tax under a single umbrella: the IRA.

The genesis of the problem here is that traditional advice pre-supposes the active management of stocks, which generates taxes that need to be avoided. The taxes created by active management are really optional since passive management avoids taxes naturally by its investment philosophy.?

This disparity between my advice and traditional advice can often be traced to advisor compensation. Commissionable advice usually leans on active transactional methods to justify the costs. This is also often true of advice involving active mutual funds, where advisors might earn 12b-1 kickbacks as incentives to “think active.” Some investors encourage this behavior by asking for tactical outcomes to feel a sense of excitement and affirmation of fleeting and irrelevant victories. Many advisors are thus incentivized to appear smart rather than wise.?

Better outcomes become more repeatable by eliminating friction points. Tax management and fee management are sure methods to decrease repeatable disadvantages and usually come with near-zero conflicts of interest. The active performance-chasing exercise can be likened to digging a hole while comparing yourself to all others also digging a hole. The friction of the process is greater than the advantage, but everybody else is doing it too.

More passive strategies like indexing or customized indexing already defer taxes by way of delayed trading and passive beta application of stock risk. Passive strategies also increase the size of powerful tax-free step-up in basis at death, compounding the benefits of passive management. Remember that IRAs are disqualified from step-ups, and higher returns from stocks in an IRA increase the ordinary income tax paid in an RMD.?

Now, let’s take optimization a step further. Customized indexing gives investors access to their biggest gainers as a funding mechanism for their favorite charities or donor-advised fund. This is why, despite the tax efficiencies of ETFs, they are not the pinnacle. The deconstructed index is the pinnacle, where you can manage the taxes of each position’s tax lot, mining for benefits in both gains and losses. Done properly, investors could lower their capital gains exposure while simultaneously generating a full tax deduction for the gift of their most concentrated gains. Some gifts can thus be made with 40-cent dollars. High net worth investors can stack these fee/tax/deferral/giving benefits and run circles around the occasionally hot mutual fund whose performance is fleeting, whose higher costs repeat, and whose tax drag reduces compounded return and sacrifices the powerful step-up rule.

You can read about these and other anti-mainstream topics in my Amazon best-seller called?FOOLISH: How Investors Get Worked Up and Worked Over By the System. Also available on Audible.

Please see?IMPORTANT DISCLOSURE?information.