A Rust-Proof Portfolio?

A Strategic Approach to Managing Taxes

Using asset-location to mitigate the corrosive effect of paying Uncle Sam

by Thomas J. Quinn, CFA

Mr. Quinn is Chief Investment & Research Officer for Jefferson National. He has 15 years of experience in the investment industry. He has served in a variety of leadership roles that leverage his portfolio management skills and specialized expertise in quantitative analysis and alternative investments, including Chief Investment Officer of a boutique consulting firm, Senior Portfolio Manager and Chief Risk Officer of a family office. Quinn is a Chartered Financial Analyst and a member of the CFA Society of Philadelphia. He earned his B.A. in Economics from Ursinus College and his M.A. in Economics from Temple University.Visit jeffnat.com

Taxes can be your clients’ biggest expense — up to 50% after federal, state and local taxes are combined. Did you know that an average American spends more days working to pay federal, state, and local taxes than they do to pay for housing, food, and clothing combined?

Taxes are not only a costly out-of-pocket expense to your clients, but also a drain on the performance of portfolios that you as their advisor worked so hard to create. In fact, 65% of respondents to the US Trust Insights on Wealth and Worth annual survey say that minimizing taxes is an investment priority for managing their wealth.

Fortunately, there are solutions. Research has shown that Asset Location is a proven strategy to mitigate the impact of
taxes on your client’s portfolio and increase returns 100-200 bps per year without increasing risk.

In this paper you will learn a more strategic approach to managing taxes with Asset Location. To help you optimize Asset Location to its fullest potential, we demonstrate how to extend the opportunity beyond the low limits of qualified plans, and how to use key indicators to assess the tax-efficiency of different asset classes and investing strategies. This paper also provides illustrative examples for implementing and extending Asset Location in a variety of scenarios and demonstrates how much value it can add.

Implementing Asset Location to Maximize Accumulation

Asset Location boosts returns by locating tax-inefficient assets in tax-deferred vehicles, and locating tax-efficient assets
in taxable accounts. With a strategic approach to mitigating taxes through Asset Location, you add more value for your
clients — helping them accumulate more wealth, generate more retirement income and leave a larger legacy.

Even with a short time horizon, Asset Location can add value, as shown in the example below (Figure 1). We look at two scenarios for a client with a starting balance of $1 million. The advisor invests $925,000 in a taxable account, and after
maxing out the client’s annual individual contribution of $5,500, their tax-deferred IRA holds $75,000. At this point, the
advisor has two choices:

  • WITHOUT Asset Location: An identical diversified portfolio allocation in the taxable account and tax-deferred IRA.
  • WITH Asset Location: A diversified portfolio in the taxable account and the most tax-inefficient assets in the
    tax-deferred IRA.

As shown in Figure 1, tax deferral adds value in both scenarios. But by taking a more strategic approach to managing
taxes with Asset Location, and placing the most tax-inefficient assets in the tax-deferred IRA, the value of tax deferral
almost doubles from $24,856 to $44,502.

Figure 1: Value of Asset Location: Additional After-Tax Accumulation Over 15 Years ($1,000,000 Starting Balance)


Data: Assume $925,000 taxable account and $75,000 IRA account. Calculated the category averages (oldest share class only) for “after tax, after liquidation 15 year return” and “15 year annualized return” from Morningstar (10/31/2015). IRA account values assume taxes are paid on full account distribution in 15 years. Assumes highest tax rates (39.6% income tax rate) now and in distribution. To compensate for the tax benefit of opening the IRA account, the value of a taxable allocation is decreased by $29,700 which was applied proportionally to each asset by its weight. This will underestimate the true value of funding an IRA over many years and investing the tax savings.

In the example above (Figure 1), the Morningstar Tax Cost Ratio is shown as an indicator of the tax-inefficiency of each
asset class. The Tax Cost Ratio measures how much a fund’s annualized return is reduced by the taxes clients pay on
distributions. For example, if a fund had a 2% tax cost ratio for the three-year time period, clients in that fund lost 2%
of their assets to taxes on average each year.

If that fund had a three-year annualized pre-tax return of 10%, a client in
that fund took home roughly 8% on an after-tax basis. The higher the Tax Cost Ratio, the more tax-inefficient the fund
historically has been. As shown above (Figure 1), asset classes with the highest Tax Cost Ratio include emerging market
bonds (2.81%), and high yield bonds (2.76%).

Extending the Asset Location Opportunity

In 2015, the maximum contribution for a 401(k) is $18,000 plus $6,000 catch up, and the maximum individual contribution for a traditional IRA is $5,500 plus $1,000 catch upiv. To maximize Asset Location, advisors need access to additional tax deferral, beyond the low contribution limits of qualified plans.

An Investment-Only Variable Annuity (IOVA) can be an effective solution to increase the size of the tax-deferred pie and
extend the Asset Location opportunity. An IOVA is designed to maximize the power of tax deferral on advisor-managed
portfolios. Several factors must be considered before choosing an IOVA for your client. Just as taxes erode performance,
so do fees and commissions.

Therefore, it is important to use IOVAs with low fees and no commissions, typically designed for RIAs and fee-based advisors. Other important considerations unique to IOVAs relate to flexibility. You will want to avoid products with a surrender charge, which can lock up clients’ assets for extended periods. You will also need to ensure that the IOVA offers a broad set of investment options, to allow you to execute your investment strategies as necessary.

Considering the same client as above (Figure 1), with a starting balance of $1 million, investing $925,000 in their taxable
account and maxing out their tax-deferred IRA at $75,000, we now examine the benefits of extending Asset Location by
using an IOVA as an additional tax-deferred account. To optimize the portfolio, while keeping in mind the client’s liquidity
needs, the advisor allocates $550,000 in the taxable account, while locating an additional $375,000 of tax-inefficient assets
in an IOVA. As shown in the example below (Figure 2), by extending Asset Location with an IOVA, the value of tax deferral
increases even further, from $44,502 (Figure 1) to $68,250 (Figure 2).

Figure 2: Value of Extending Asset Location with an IOVA: Additional After-Tax Accumulation Over 15 Years
($1,000,000 Starting Balance)

Data: Assume $550,000 taxable account, $75,000 IRA account and $375,000 IOVA. Calculated the category averages (oldest share class only) for “after tax, after liquidation 15 year return” and “15 year annualized return” from Morningstar (10/31/2015). IRA account values assume taxes are paid on full account distribution in 15 years. Assumes highest tax
rates (39.6% income tax rate) now and in distribution. To compensate for the tax benefit of opening the IRA account, the value of a taxable allocation is decreased by $29,700 which was applied proportionally to each asset by its weight. This will underestimate the true value of funding an IRA over many years and investing the tax savings.

Key Indicators of Tax-Inefficient Asset Classes and Strategies

The first step in executing an effective Asset Location strategy is to identify the tax-inefficient areas of your clients’
portfolios. When advisors choose mutual funds over building portfolios of stocks and bonds themselves, they give up having total control of the client’s tax bill. Mutual funds will distribute taxable income, dividends and gains based on what happened
in the fund during the year.

Most fund companies gauge their managers’ success on pre-tax performance and provide incentives accordingly. As a result, managers often ignore the potential tax implications of their investing strategy. Certain asset classes such as fixed income, are inherently tax-inefficient. For example, a client invested in high yield bond funds over the past ten years would have paid more than 41% of their return to taxes on distributions.

Other assets are tax-efficient, but can become tax-inefficient based on how they are managed. Beyond the tax distributions of the funds, the allocation approach of the advisor can impact tax-efficiency. The use of tactical allocation strategies designed to take advantage of shorter term market opportunities can turn tax-efficient funds into a tax-inefficient portfolio.

Tax-efficient asset classes will defer realizing gains as long as possible, generating long-term capital gains and
dividends, currently taxed at rates of 20% or less. Tax-inefficient assets will generate ordinary income or short-term
capital gains, currently taxed at rates as high as 39.6%.

An effective way to identify inefficient fund holdings is evaluating historical return and tax statistics readily available
through sources like Morningstar:

  • • After-tax returns versus pre-tax returns: A simple measure that can help you understand how much of a fund’s total
    return your client will keep after taxes.
  • Morningstar Tax Cost Ratio: As previously noted, this ratio measures specifically how much of a fund’s annualized
    return is reduced by the taxes investors pay on distributions. The following chart (Figure 3) illustrates how the inherent
    tax-inefficiency of fixed income and alternatives results in a higher Tax Cost Ratio when compared to equities.

Keep in mind that the Tax Cost Ratio provides a retrospective look, reflecting the historical performance of an asset held
for a long time horizon, which may not be the most likely outcome in the future. To take a more prospective stance and
be more forward looking when assessing the tax-inefficiency of clients’ assets, you should evaluate additional indicators,

  • Yield of fixed income: The mix of income and capital gains generated can directly impact the tax bill.
  • Tactical allocations to equity funds: Short horizon trading leads to more short term capital gains and higher taxes.

The Impact of Yield on Tax-Efficiency

Unlike the days of buying and holding individual bonds to maturity, fixed income funds offer diverse strategies with
significant turnover. These funds offer a blend of capital appreciation and income. The amount of return coming from yield
(defined as the income return on an investment) is directly related to the size of the tax bill.

Fueled by low default rates and favorable credit conditions, investors in 2015 have been moving into high-yield debt funds. Yet these are inefficient, because they pay more of their return as income, taxed at the highest rates. Bank loans have also increased in popularity, but are even more tax-inefficient. During periods of falling rates, their floating rate coupon limits capital appreciation, which is taxed more favorably, while greater than 100% of total return has been paid out as income, taxed at the highest rates. On the other hand, long-term government bonds have seen more capital appreciation and less income in the past decade, making them more tax-efficient.

To demonstrate the value of using Asset Location for high yield bond funds, we again look at the same client from our
previous examples (Figure 2), with a total starting balance of $1 million, including $80,000 in high yield bond funds.
Comparing the additional return over time when investing these high yield bond funds in a taxable account, versus locating
them in a tax-deferred vehicle, we can see the benefit of compounding the client’s tax savings through Asset Location.
Over 20 years, Asset Location would generate an additional $41,414, or 27% more accumulated wealth. Over 30 years,
Asset Location would generate an additional $116,786, or 55% more accumulated wealth.

The Impact of Tactical Trading on Tax-Efficiency

Tactical allocation strategies try to improve the risk/return profile of a portfolio by actively shifting allocations across
investments. This return seeking turnover has the potential to lead to more short-term capital gains — and higher tax
bills. Evaluating equity investments requires looking at the investing and allocation strategy. While passively managed
equity funds tend to be tax-efficient, actively managed funds or tactical advisor trading are more tax-inefficient.

Currently, low yields, volatility and low cost portfolio options have increased the demand for new solutions that generate
improved returns for clients. In response, many fund managers and advisors are using tactical strategies. Regardless
of whether it is the fund itself generating short-term gains, or whether it is the advisor’s own management strategy,
the results are the same — higher client tax bills. Locating these investments in a tax-deferred vehicle can mitigate the
negative impact of short-term capital gains and the full benefit of the tactical strategy can be realized.

Figure 7 shows the impact of realized short-term capital gains on breakeven points — the point when an asset will
perform better in a tax-deferred vehicle than in a taxable account. Correspondingly, Figure 8 shows how short-term
capital gains impact the value of tax deferral over 20 years. Typically, clients will have less taxable income in retirement,
and this lower tax bracket can dramatically improve the value of tax deferral. Therefore, we assume that the client is currently earning $300,000 (33% marginal tax rate and 15% rate on long-term gains) and will generate $200,000 income in retirement (28% marginal tax rate and 15% rate on long-term gains).

Long-term investment horizons or actively offsetting gains with losses can minimize taxes, which
means the breakeven point takes longer. For example, a buy and hold equity, with no short-term capital gains, has a
breakeven of 28 years. When turnover is high, and realized short-term capital gains go up, the breakeven point
comes sooner.

Likewise, short-term capital gains impact the value of tax deferral over 20 years. As the tactical
allocation strategy drives realized short-term capital gains to increase, the benefit of tax deferral rises. As realized capital
gains increase from 15% of the total return to 30% of the total return, the value of tax deferral over 20 years more than
triples from $18,661 to $70,119.


In recent years, US tax rates have increased, creating an even larger tax bill for clients. This year, Americans will pay a
total tax bill of $4.8 trillion, or 31% of national income.iii By implementing an Asset Location strategy that leverages the
power of tax deferral, you can minimize the impact of taxes and help your clients grow more wealth. Research has shown
that Asset Location can increase returns by 100 – 200 bps per year — without increasing risk.

Asset Location can add value in many scenarios. Certain asset classes, such as fixed income, are inherently
tax-inefficient. Other assets may be tax-efficient, but become tax-inefficient based on how they are managed. Asset
Location can be especially effective for mutual funds and ETFs, which can have unexpected tax consequences. These
funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders, who must pay taxes on
those distributions during the year they were received. Even if shares are not sold, even if a fund has a loss, your clients
may still face a tax bill at year-end on capital gains distributions of these funds. If markets continue to rise, your clients
are likely to see a corresponding rise in these capital gains distributions.

Tax-inefficient assets perform best when located in tax-deferred accounts such as IRAs and 401(k)s. But many clients
can benefit from extending Asset Location beyond the low contribution limits of these qualified plans. A new category
of tax-deferred account, the Investment-Only Variable Annuity (IOVA), allows you to maximize the power of tax deferral
and increase the size of the Asset Location opportunity for your clients — especially the high earners and the high net
worth. When evaluating Investment-Only VAs for this purpose, it is important to utilize an IOVA with low or flat fees, no
commissions, no surrender charges and an expanded lineup of underlying funds.

In this challenging environment of high taxes, a strategic approach to tax-advantaged investing with a low-cost IOVA can add greater value for your clients, and your firm.


Read the entire report here.

About Jefferson National
Jefferson National is a recognized innovator of a leading tax-advantaged investing platform for RIAs, fee-based advisors
and the clients they serve. Named the industry “Gold Standard” and winner of more than 45 industry awards, including
the DMA 2010 Financial Services Company of the Year. The company serves advisors and clients nationwide, through its
subsidiaries Jefferson National Life Insurance Company and Jefferson National Life Insurance Company of New York.
To reach our advisor support desk, please call 1-866-WHY-FLAT (1-866-949-3528). To learn more, please visit
Important Disclosures
Past performance is no guarantee of future results.
Morningstar makes the following general assumptions for the after-tax return methodology. Many of these assumptions were outlined in the SEC’s guidance to mutual fund companies about this calculation. 1) Distributions are taxed at the highest federal tax-rate prevailing for each type of distribution. After-tax proceeds from those distributions are reinvested. 2) The appropriate current or historical federal tax rate is applied to each distribution based on the distribution date. 3) State and local taxes are ignored. 4) The calculation does not reflect the tax effects of the alternative minimum tax, exemptions, phase-out credits, or any individual-specific issues. 5) The returns reflect all recurring built-in fees and nonrecurring charges like sales loads. 6) Sales loads are not applied to reinvested distributions. 7) Front-loads are the only fees charged at the start of an investment period. 8) As per industry practice, the deferred load is applied to the lower of either the beginning NAV or the ending NAV of the original shares purchased. 9) If the deferred load is structured on a sliding, time-based scale, Morningstar uses the lower of the two amounts that straddle a specific time period. For example, if a fund has a deferred load of 6% for year 0-1 and 5% for year 1-2, Morningstar will apply the 5% load to the one-year after-tax return calculation.
An investor should carefully consider the investment objectives, risks, charges and expenses of the investment before investing or sending money.
The contract prospectus and underlying fund prospectuses contain this information. For a prospectus containing this and additional information, please contact your financial professional. Read it carefully before investing. The summary of product features is not intended to be all-inclusive. Restrictions may apply. The contracts have exclusions and limitations, and may not be available in all states or at all times. Variable annuities are investments subject to market fluctuation and risk, including possible loss of principal. Your units, when you make a withdrawal or surrender, may be worth more or less than your original investment.
Variable annuities are long-term investments to help you meet retirement and other long-range goals. Withdrawal of tax-deferred accumulations are subject to ordinary income tax. Withdrawals made prior to age 59 ½ may incur a 10% IRS tax penalty. Jefferson National does not offer tax advice.