How to Lose Less

Adam M. Grossman

IF THERE’S ONE STORY that seems to have captured the investing public’s imagination this summer, it’s the revelation that venture capitalist Peter Thiel has managed to accumulate more than $5 billion in his Roth IRA—where it will be entirely tax-free to him.

In its reporting, ProPublica, the news outlet that carried the story, focused mostly on the tax aspects—the fact that Thiel was able to use his Roth IRA in such unusual ways. In my opinion, though, the more notable element of this story is simply that Thiel was able to turn an initial investment of just $1,700 into more than $5 billion. That was the hard part.

The tax strategy, on the other hand, wasn’t exactly simple, but it wasn’t so difficult, either. Stories like this, in fact, are a reminder that taxes are—to some extent—within our control. This is especially true when it comes to investment-related income.

We all know the basics of tax-efficient investing: asset location, tax-loss harvesting, charitable giving and, of course, using tax-advantaged accounts like Roth IRAs and 529s. I definitely endorse these strategies. But those aren’t the only ones. Here are three more to keep in mind:

Indexing. When it comes to the active vs. passive debate, most people focus mainly on the performance advantage of index funds. But there’s another key reason to steer clear of actively managed funds: taxes.

Here’s how the research firm Morningstar summed it up: “Over the past five years, Morningstar’s Tax Cost Ratio—a measure of the reduction in returns from taxes on fund distributions—has averaged about 1.8% for U.S. equity funds,” adding that, “the return hit from taxes is nearly twice as large as that from annual expenses…”

To put that in perspective, the U.S. stock market’s average annual return has been about 10% historically—so that 1.8% represents a material drag. If you own an actively managed fund and are wondering whether to cut it loose, I recommend checking Morningstar for the fund’s Tax Cost Ratio, along with its turnover ratio and historical distributions.

Direct indexing. As much as I recommend index funds and advise against stock-picking, individual stocks do carry one interesting benefit: They offer the potential to be more tax-efficient. To illustrate, imagine that 10 years ago a brother and sister each used their regular, taxable account to build a portfolio to track the S&P 500, but they went about it differently. The brother went the conventional route and bought an S&P 500 index fund.

Meanwhile, the sister bought all 500 stocks individually. Today, they would both be sitting on approximately 300% gains. But the brother—with the index fund—is in a tougher spot tax-wise. That’s because his shares (excluding those bought with reinvested dividends along the way) all have an identical gain of 300%, so most shares he sells would result in the same 300% gain. There would be no way around that.

The sister, on the other hand, has a much more complicated portfolio but also a lot more flexibility. That’s because each of those 500 stocks has fared differently over the past 10 years. Some have seen big gains, but dozens—GE, for example—have actually lost value. As a result, the sister can pick and choose which stocks to sell at any given time, giving her much more flexibility to control her tax bill.

Why am I talking about individual stocks? To be clear, I don’t recommend that anyone rush out and load up on stocks like this. I mention it, though, because index fund providers recognize the tax-related shortcoming of their products and are working on solutions. One such solution looks promising: It’s called direct indexing. In a sense, it’s like an investor’s own personal index fund. This allows investors to capture the tax efficiency of individual holdings without the associated portfolio complexity.

Direct indexing also allows investors to tailor portfolios in ways that aren’t possible with conventional funds. You could, for example, buy most S&P 500 companies, while excluding those that run contrary to your values, such as tobacco companies.

Not surprisingly, two of the largest index-fund managers have acquired direct indexing companies. BlackRock bought a company called Aperio, and just last week Vanguard announced the acquisition of a firm called JustInvest. The cost of these services is still a little high. But as they expand, I expect prices will come down. This is a trend worth keeping your eye on.

Borrowing. Ed­ward Mc­Caf­fery, a law professor at Uni­ver­sity of South­ern Cal­i­for­nia, uses the phrase “buy-borrow-die” to describe another tax strategy. This is how it works: Suppose you have a large portfolio of stocks held in a taxable account and need money for expenses. You could sell some of those investments, but that would trigger capital gains.

An alternative would be to borrow against your shares. When would you pay this loan back? You wouldn’t. Instead, your estate would—after your death. Because of the step-up in cost basis on taxable account investments, your estate would be able to sell shares tax-free and pay off the loan at that point.

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Mc­Caf­fery says that, “Or­di­nary peo­ple don’t think about debt the way billionaires think about debt.” But you hardly need to be a billionaire to employ this strategy. You do, however, need to be careful. First of all, borrowing rates vary widely from broker to broker.

Second, you don’t want to borrow too much. That’s because, unlike most other consumer loans, a broker can demand repayment if the market drops and your loan balance gets too high relative to the now-reduced value of your portfolio. In that situation, if you don’t have the cash to pay down the loan, the broker has the right to sell some of your investments. This is an ugly phenomenon known as a margin call and something you want to avoid. Finally, as always, taxes should be only one factor in any investment decision. In other words, don’t stick with an inappropriate portfolio just to save on taxes.

A further note on the buy-borrow-die strategy: Today in Washington, DC, legislators are debating a proposal to scrap the step-up at death that’s a key pillar of this strategy. If Congress does go that route, it would largely upend this strategy. But borrowing might represent a solution to another proposal being debated. If capital gains rates rise for high-income taxpayers, it would become more important to limit—or at least smooth out—your income from year to year.

Suppose you wanted to sell some of your investments to buy a new home. Under the proposed new system, there might be an incentive to spread those sales over a period of years to keep your income under each year’s new threshold for higher capital-gains tax rates. It’s an open question where this legislation ends up. But if it does pass as proposed, short-term borrowing might become a more valuable tax technique.

The bottom line: For many people, “tax time” is when returns for the prior year must be completed. But I recommend flipping this script. Don’t view tax time as solely an exercise in looking backward. Instead, take the opportunity to look forward, strategizing for future years. That way, you’ll be able to look at your tax bill as something that’s controllable rather than inevitable.

A final note: I’ve gotten more than one question about Peter Thiel’s use of his Roth IRA to buy shares in startup companies. If you’re interested in this strategy, there are two important things to know. First, it’s actually not too difficult. You just need to work with a custodian that specializes in this. But second, you do need to tread extremely carefully. That’s because the IRS’s rules around this are very specific and the penalty for a misstep is severe. The IRS can disqualify an IRA, making the entire account taxable all at once. If you’d like to learn more, I recommend this detailed writeup by accounting expert Jeffrey Levine.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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11 months ago

There are some tax-managed active funds that employ some direct index techniques. For example, Vanguard has three: large cap, small cap, and balanced. There are certainly others as well.

11 months ago

Instead of making withdrawals from our IRAs, we’ve been keeping our taxable income lower by simply using our HELOC. A no-brainer decision that helps us get lower cost health insurance.

Roboticus Aquarius
Roboticus Aquarius
11 months ago
Reply to  Guest

That’s an interesting idea. Do you mind if I ask whether this will this cause you to pay higher taxes over time on the foregone withdrawals, or did you already fill up the lower tax brackets such that the gap is negligible? How much do you think this saved in health care costs?

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