Tax-Optimized Householding

What is householding and what’s required to do it well?

At the In|Vest Conference in New York earlier this month, we unveiled our forthcoming household rebalancing functionality that automates optimal management of a group of accounts belonging to one household. That’s great (we’re very proud), but it does raise a question: what is householding and what does it mean to do it well? We’d like to answer that.

“Householding” means jointly managing multiple accounts (like a 401K, a Roth IRA and a taxable account) to a single asset allocation. Doing it well means simultaneously 1) managing each individual account well, and, 2) managing the household well. Let’s break this down.

Managing Each Individual Account Well

What does it mean to manage an individual account well? It means obeying constraints and optimizing taxes. Specifically:

• Managing taxable accounts well means:
• Minimizing capital gains and taking advantage of tax-loss harvesting opportunities.¹
• Implementing tax-sensitive transitions and withdrawals, maybe imposing tax budgets. 
• Managing tax-deferred accounts well means:
• Avoiding withdrawal penalties. 
• Avoiding buying muni-bonds or other vehicles designed for taxable accounts. 

And, in all accounts, obey buy list, security, sector and ESG constraints. 

There’s not exactly anything new here. The thing that changes is that you don’t need to make sure every account is, by itself, properly diversified. That becomes an attribute of the household as a whole.

Managing a Household Well

None of this goes away when you’re managing a group of accounts in a household. But householding done well involves more than just managing each individual account well. It requires a holistic view of both asset allocation and taxes. Specifically, householding done well means :

• Ensuring that the holdings of the multiple accounts, if combined, mimic the target asset allocation for the household as a whole. (This is pretty much the definition of householding.)
• And implementing household-level tax optimization. For advisors who are used to tax-optimization at the account level, this household-level tax optimization is new. It involves:

• Avoiding wash sales across accounts.
• Coordinating trades across accounts to avoid selling, reducing exposure to an asset class in one account, and simultaneously increasing it in another.
• Minimizing the tax effect of sales by preferentially realizing losses in taxable accounts and gains in tax-advantaged accounts.
• Minimizing future taxes by putting assets that generate taxable income in tax-advantaged accounts.²

Jointly managing a household’s accounts is not a new problem, but we’re seeing a rising interest in doing it reliably and well, part of a larger industry trend away from a performance-based value proposition to a value proposition that stresses planning and workmanlike professional execution. 

Doing householding well is complex, and doing it manually would be prohibitively expensive for all but ultra-high net worth accounts. The good news here is that every element of account and household management we’ve mentioned can be automated, which makes it economically feasible to offer high-end householding to all investors. 

¹Tax loss harvesting gets more attention but gains deferral (avoiding capital gains) is the core of optimal tax management — generating more than ¾ of the value. Gains deferral gets less attention simply because it’s harder to do well. Gains deferral means holding onto some or all of a position for tax reasons, meaning that but for tax considerations, you’d sell it. When you do this, you create drift. The key to gains deferral is minimizing this drift by smart counterbalancing — carefully balancing what you overweight with what you choose to underweight. See Gains Deferral: The Core of Tax Management

²The last two tax minimization strategies can conflict with each other. The best way to minimize capital gains is to do most of your rebalancing in a tax-advantaged account. This dictates making sure the tax-advantaged accounts have holdings in every asset class. On the other hand, the best way to minimize tax on income is to load up tax-advantaged accounts with securities generating interest and short-term gains. It’s not clear how to reconcile these two strategies. Do you concentrate all your tax-inefficient product in your tax-advantaged accounts or keep a mirror copy of your whole strategy there? And, if you start with a suboptimal distribution, what level of trading costs and taxes are you willing to bear in order to make it better? To get all of this right, you would need to know not only how much income different securities will generate, but also how often you’re going to be trading.