• Malissa Marshall, CFP®, EA

How Do You Build A Well-Structured, Tax Efficient Portfolio?

Updated: 2 days ago

Your portfolio plays a significant role in your financial life. When structured to reflect your goals, it can help you build wealth for future endeavors and find financial freedom.

A healthy portfolio is a coveted commodity for any investor, but few know how to build and sustain one for the long-term. While the financial markets are riddled with technical skills and applications, portfolio creation and management don’t need to be as difficult as they seem.

Below I will outline three basic tenets to crafting a balanced investment portfolio.

1. Have a firm grasp of diversification

Diversification is an essential strategy for any investor. It aims to mitigate risk by allocating investments across different economic sectors and amass a collection of securities that react differently to market conditions. When wielded properly, this strategy protects you from overexposure in one area and underexposure in another.

To work, you need to understand the type of risk you are dealing with. The two general types you should know about are:

  1. Market risk, and

  2. Diversifiable risk (company-specific risk).

Market risk encompasses external factors like inflation, exchange rates, and interest rates, whereas diversifiable risk focuses on the company or industry itself. While market risk is a byproduct of any investment, diversifiable risk can be curbed through (you guessed it) diversification.

How it works and why it matters

Remember, diversification asks the investor to look at their specific allocations. This means honing in on the actual securities you are investing in to ensure that they are representative of a variety of companies, industries, locations, and asset classes. What does this look like in practice? Let’s take a look at each of these ideas individually.

To diversify your portfolio across different companies, that would mean ensuring that you hold equity (stock) in several businesses. If you work for pharmaceutical giant Pfizer, for example, you wouldn’t simply own Pfizer stock, you might also own stock in other pharma companies, tech, natural resources, and more. This leads us to the second point, diversifying across industries.

If you only own stock in technology companies and big tech experiences a significant drop, your portfolio could see substantial losses. But if you diversified your portfolio to include technology, energy, finance, and pharmaceutical sectors, the loss of your technology stock would be countered by the other industries to help bring balance to your portfolio.

It is also wise to diversify based on location which means you might consider investing in foreign markets as well as domestic.

The last way you can add diversification into your portfolio is through different asset classes. This means investing in stocks, bonds, mutual funds, ETFs, and more. Assets like stocks and bonds don’t often react the same way to market events. A healthy combination (depending on your level of risk) can help allay the effects of big market swings.

How to maintain a diversified portfolio

Critics of diversification claim that it is difficult to maintain and can run up a lot of expenses in trades and fees for the investor.

But the best way to maintain a diversified portfolio is to proactively rebalance your portfolio on a quarterly or even annual basis. This way, you can make necessary adjustments without incurring as many taxes and fees by constantly buying and selling new securities.

2. Make the most of asset location

Earlier, we alluded to asset allocation, the strategy that seeks to balance risk and return by filling your portfolio with securities that take your risk tolerance, investment goals, and time horizon into account.

Asset location, on the other hand, is a strategy that seeks to infuse tax-efficiency into your portfolio by placing individual securities (stocks, bonds, ETFs, etc.) in the most tax-efficient account (IRA, brokerage account, 401k, etc.). This strategy is a bit more complex and asks that the investor considers the tax ramifications of each account and which securities will perform best where.

Let’s take a look at the three different types of accounts and which assets tend to work best in them.

1. Taxable account

Taxable accounts, like a brokerage account, don’t carry any inherent tax benefits but also come with fewer restrictions than other tax-advantaged accounts. You can sell securities at any time with no penalty, but the sale will trigger capital gains tax (long or short-term depending on how long you held the security). Securities that do well in taxable accounts are usually ETFs, mutual funds, municipal bonds, and other long-term equity securities.

2. Tax-deferred account

Like a 401k, traditional IRA, or 403b, these accounts allow investors to contribute money tax-free and defer the tax payment until it is withdrawn. All distributions are taxed as ordinary income. Examples of securities that perform well in these accounts are real estate investment trusts, taxable bonds, and high turnover/actively managed stock funds.

3. Tax-exempt account

These accounts require the investor to pay taxes upfront but not at the point of distribution. Key examples are Roth IRAs and Roth 401ks. Many securities perform well here, similar to that of the tax-deferred account.

Deciding where to house different securities comes down to the tax efficiency of the particular investment. Tax-efficient investments like individual stocks and ETFs tend to do well in a taxable account. On the other hand, tax-inefficient assets like bonds and actively managed funds do better in tax-deferred/exempt accounts.

In addition to properly housing your securities, you want to ensure that you’re maintaining an appropriate cash reserve for periodic withdrawals like RMDs, monthly retirement “paychecks” and larger one-time expenses like a home remodel or an extended vacation.

3. Keep taxes and fees at bay

A well-balanced portfolio doesn’t just mean accumulating assets and shuffling securities. To find true success, you need to understand the long-term impact that taxes and fees have on your portfolio gains.

There are two different types of tax treatments for your investments that you should be aware of.

  1. Capital gains

  2. Ordinary income

Capital gains taxes are usually much more favorable, especially long-term capital gains (ranging from 0-20%—short-term can be as high as 37%). It’s important to create a long-term strategy around the capital gains you incur in any given year to make the most of your investments and maintain the health of your portfolio.

Fees are another area that many investors underestimate. Fees play a big role in your net gains, especially when investing in larger mutual funds. Some of the most common types of mutual fund fees to watch out for include:

1. Fund fees

Any ongoing fees to cover the costs of managing and operating the fund. These can be anything from management fees, administrative costs, legal, and marketing the fund (12b1).

2. Shareholder fees

Commissions and one-time costs associated with buying and selling shares. These could be account maintenance, sales loads, purchase fees, and redemption fees.

Keep in mind that most of these fees aren’t charged upfront, rather as percentages of your account, which results in lower long term growth. It’s important to know the total fees associated with a mutual fund before you decide to invest.

A good indication of the fees will come from the type of fund management. Active management tends to have higher fees as fund managers are making more trades whereas passive management tends to keep fees more minimal as trading frequency decreases, but there are many nuances to understanding mutual fund fees.

Working with an advisor you trust can help bring transparency and clarity to the process, providing added confidence in your investment choices. If you are ready to learn more about how to structure an investment portfolio that is right for you, schedule a call with us today.


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