The Tax-Smart Portfolio: Keeping More of What You Earn

by Cathy S. Butler, Morgan Stanley

Every investor is looking for an edge that helps them boost their overall wealth. But one strategy that some don’t pay enough attention to is tax-efficient investing. The reason? Even small reductions in tax costs can have enormous consequences for wealth accumulation.

In an example drawn from a Morgan Stanley report, an improvement of 0.6 percent per year in after-tax returns resulted in a remaining wealth difference of 75 percent after 30 years of distributions—no small improvement. “People are often surprised to learn just how much of their long-term investment returns go to taxes, and how much of a difference that can make in terms of whether or not they will meet their financial goals,” says Lisa Shalett, Morgan Stanley Wealth Management Head of Investment and Portfolio Strategies.

Faced with a shortfall between lifestyle plans and wealth accumulation, some investors consider options like delaying retirement or taking on more investment risk in an attempt to boost returns. But a key strategy for boosting long-term returns—which may not necessarily add risk—is being smart about tax efficiency.

Utilizing a Variety of Strategies
The benefits of tax-deferral vehicles such as 401(k)s and Individual Retirement Accounts are well known, and naturally, a tax strategy should start by utilizing those vehicles. For many people, the simple strategy of deferring taxes as long as possible can be effective, because it allows your investment earnings to compound without the headwind of a front-end tax payment. Depositing earnings in a tax-deferred 401(k) or IRA, with the possible addition of a tax-exempt Roth IRA, is a typical option.

Another option is to put aside money for specific categories of spending, like education and healthcare, using tax-deferred accounts such as 529 Education or Health Care Savings Accounts.

But there are also lesser-known strategies that can meaningfully add to your long-term wealth. Compared to a 401(k), the additional annual returns generated by these strategies may seem small. But just as the power of compounded interest can help small, early-career contributions balloon over the decades, small losses due to taxes can snowball over a lifetime.

For example, higher-income investors who can max out their tax-deferred retirement accounts can add additional strategies, such as investing in tax-exempt municipal bonds and utilizing “tax-managed” investment products that hold gains and “harvest” losses to create tax losses. As with qualified retirement accounts, tax-managed investment strategies work by deferring tax costs into the future.

For high-net-worth investors, insurance and annuities products can also be effective in helping to reduce the impact of taxes on lifetime wealth. These include:

  • Investment-Only Variable Annuities (IOVA). Investors who have hit the contribution or income caps for pre-tax retirement accounts such as 401(k)s and IRAs can direct post-tax savings to an IOVA, where investment gains are not taxed until they’re withdrawn. This relatively new vehicle is designed for wealth accumulation, coming without the more costly features of other variable annuities, such as guaranteed withdrawal benefits, but with a broader menu of investment options. Its impact on wealth generation is greatest for investors with a long time horizon.
  • Universal Life Insurance. Another avenue for individuals who have maxed out their qualified retirement accounts, these policies combine potential wealth accumulation with protection for family in the event of the investor's death. For a set term, the policy buyer pays premiums, the majority of which—after fees and the cost of insurance—are invested in the markets. After the initial term, the cash balance grows tax-free. Subject to certain restrictions, the cash value of a universal life policy can be accessed tax-free, initially through withdrawal of principal, and subsequently by loans against its death benefit.

For most people, one or more of these products and account types can help them improve their tax efficiency. Their full potential to provide a boost to after-tax returns, though, can only be unlocked when they are set up as building blocks in a more complex, integrated tax strategy.

For example, when you have a mix of accounts and products with different tax treatments, you can increase the impact of the tax-advantaged accounts through “tax-efficient asset location,” where investments are sourced per account according to their growth potential and relative tax efficiency.

A Smart Withdrawal Strategy
A retirement income plan is another way in which the different components of a tax strategy can complement one another by sequencing withdrawals in a tax-efficient way. A simple withdrawal sequence might involve withdrawing from taxable accounts first and tax-advantaged accounts last. However, according to Daniel Hunt, Morgan Stanley Wealth Management Senior Asset Allocation Strategist, even more complex withdrawal sequencing strategies can have a significantly greater impact on lifetime spending power.

For example, distributing savings that don’t register as taxable income—like withdrawals from a universal life insurance policy—while converting portions of tax-deferred savings into a Roth IRA can “smooth your reported income, so you pay lower average rates, while continuing to shelter your investments from tax.

"Overall, how these different approaches are combined can make a significant difference when it comes to building wealth over the long term,” Hunt says. “Each of them can be helpful in and of themselves, but in concert they can provide much more significant compounded benefits that can really move the needle. If you have an advisor who's willing to sit with you and put together a comprehensive strategy where the pieces work together, that can make all the difference.”

If you haven’t taken a look at how tax-efficient investing can help lower your tax burden and increase long-term wealth, talk with your financial advisor or private wealth advisor. iBi

Cathy S. Butler, CFP, CRPC is a financial advisor with Morgan Stanley. For more information, visit