Performance Differences Among Accounts

All of our clients receive an investment education session that typically is over an hour in length. It is sort of a “rite of passage”. One important subject presented is how different types of mutual funds are better suited to be held in the various types of accounts the client might have. Much of this suitability is due to the tax characteristics of the various types of accounts and the types of mutual funds they are to hold. We also explain how all their accounts are managed as one, integrated portfolio.

So when we receive questions from a client questioning why one type of account did better (or worse) than holdings in another type account, it is likely they have forgotten their investment education session, or at least that part of it.

One can invest in many things through the medium of mutual funds. Small company stocks, blue chip stocks, international stocks, various types of international and domestic bonds are but a few examples. Some mutual funds are very tax efficient, some are very tax inefficient; most mutual funds fall somewhere along the spectrum.

Our typical client has a number of accounts with different tax characteristics. They usually come to us with a joint account for investment of after-tax money (i.e., money they have earned, saved and invested, on which they have paid income tax). Often they will have regular individual retirement accounts (IRAs). If they don’t have Roth IRA accounts, they very likely will after our planners advise them. There might be other accounts, such as 401k accounts that are very much like regular IRAs except there are fewer choices of investments. Designing a portfolio that puts these different types of money to work properly in a diversified portfolio of mutual funds is something of an art form.

Let’s look at how a typical diversified portfolio of mutual funds might be constructed with the varying types of accounts.

Regular IRAs are good tax shelters, at least while the owner is stashing away pre-tax money in them for retirement. After the owner has retired and starts withdrawing from the account, with few exceptions, income tax must be paid on those withdrawals. For this reason, regular IRA accounts are called “tax deferred” because eventually someone is going to have to pay income tax as contributions and capital gains are withdrawn. Thus, regular IRAs are great places to hold tax inefficient funds. These funds might be tax-inefficient due to having a lot of dividend income, interest income, or capital gain income (generated by much buying and selling of fund holdings during the year). Growth and income, real estate, small capitalization, taxable bond, and equity income funds are examples.

Whereas regular IRAs are tax deferred, Roth IRAs are funded by after-tax contributions that are limited in size. Both the contribution amount and the growth of investments are tax free when withdrawn. Because of this tax characteristic, high-growth funds best reside in Roth IRAs. Assets can grow to their little heart’s content and not generate a penny of tax bill! However, one must remember that there is no such thing as a high-return, low-risk investment. Thus, as the volatile, high growth investments of a Roth account fluctuate, the growth will vary pretty widely.

Mutual funds bought with after-tax, non-Roth money need to be tax efficient. They will be held in individual or joint accounts in which every dividend, interest receipt and capital gain is taxed. A capital gain (or loss) is generated whenever a mutual fund manager sells one of his fund’s holdings or when we sell some mutual fund shares to generate cash the client needs for living expenses. Thus, these accounts are best at holding mutual funds for which the fund manager limits selling (“low turnover”) and receives few dividends and interest payments. Good value funds, index funds or municipal bond funds would be candidates for holdings in these type accounts.

The purpose of this article is not to equip the reader to design portfolios. Rather, it is to provide some insight on how and why our clients’ various accounts perform at different levels in different market environments. We at HSC love it when clients have a combination of taxable, IRA and Roth IRA money to invest. That means we can invest those clients in mutual funds that will “fit” in an appropriately taxed, tax deferred or tax free account, where their long term performance can be optimized. In that regard, we love diversity!