As you build client portfolios, don’t let taxes take a back seat to risk and cost considerations. Taxes can be a big drag on your clients’ returns, so it’s important to structure their accounts for what really matters – after-tax returns. Use BlackRock’s “Fill First” framework to help you get started.
Setting the stage
Risk and return have been a pillar of portfolio construction since Markowitz introduced Modern Portfolio Theory in 1952. Then came the focus on fees with the advent of indexing in the early 1970’s. When building portfolios, risk and fee considerations are paramount, but it only gives investors part of the picture.
BlackRock believes taxes can also present a big drag on portfolio returns. Hence, structuring your clients’ accounts for what really matters, after-tax returns, can help you maximize returns that your clients can actually spend. As they say, “It’s not what you make. It’s what you keep”.
It’s not what you make. It’s what you keep.
This is where BlackRock’s "Fill First" strategy can help your clients keep more of what they earn. The objective of the strategy is to take a total view across investment accounts. Remember, money is money, no matter where it sits, so you want to make sure your clients’ IRA and taxable accounts work together towards a common goal.
Here is how it works - think about it like filling buckets using pitchers of water. The buckets are your accounts – your tax-deferred IRA and your traditional taxable account. The pitchers are your assets – bonds, equity ETFs and active equity mutual funds.
Let’s start with two guiding principles:
• Rule #1 - Bonds
Fill your clients’ tax-deferred IRAs with taxable bonds, like corporates, before allocating to bonds in the taxable accounts.
• Rule #2 – Equities
Anchor your clients’ taxable accounts with buy-and-hold equity ETFs.*
Maximizing after-tax returns, one step at a time
Now, let’s see these steps in action for a hypothetical client with $1,000,000, looking to split assets across their IRA and taxable accounts.
Step #1 is to fill IRAs with higher yielding taxable bonds.†
Many investors pay income tax on interest paid out by bonds and as a result, choose to invest in municipal bonds for tax-advantaged income. The problem is that municipal bonds typically pay lower interest rates. The solution is to fill your clients’ tax-deferred IRAs with taxable bonds that seek higher yields so that they can defer taxes until withdrawal† – where they’ll likely be in a lower tax bracket. If they need more bonds than their IRAs can hold, complete their fixed income allocation in their taxable account.
Step # 2 is to fill taxable accounts with ETFs.
To diversify, investors have turned to ETFs or active mutual funds or both, depending on their needs, but where you put each matters. ETFs tend to distribute fewer capital gains than active mutual funds, making them more tax efficient. This makes buy-and-hold ETFs a good anchor for taxable accounts* to help minimize capital gains taxes.
Anchor your clients’ taxable accounts with iShares ETFs.
Step #3 is to overweight mutual funds in IRAs.
Equity ETFs are also well suited for IRAs, so it’s a matter of preference. If clients seek outperformance with mutual funds, consider overweighting them in their IRA first.
Active equity mutual funds seek to outperform the market but trade a lot to do so. This can lead to capital gains distributions for fund shareholders, and that means taxes. Putting active mutual funds in IRAs can give active managers their best chance to shine in the absence of capital gains. If your clients want to allocate more to active equity mutual funds than their IRA can hold, put any remaining allocation in their taxable accounts.
Give BlackRock’s Active Equity mutual funds a chance to shine in your clients’ portfolios
BlackRock believes that investing for after-tax returns is the third wave of modern portfolio design. The “Fill First” strategy can help guide the way. Differentiate your practice with a focus on after-tax returns to help your clients keep more of what they earn.
Interested in learning more? Access our 201 insights content on reducing taxation through asset location.
Leverage our client one-pager to illustrate to your clients the importance of after-tax returns.
