Everything you’ve always wanted to know about householding*

*But were afraid to ask.

Householding! For some advisors, it’s an afterthought. For others, it’s critical. But the trend is pretty clear. For reasons we don’t fully understand (though we have some ideas), we’re seeing a big increase in interest in householding among prospects and clients. We’re delighted by the trend, but, complicating things, “householding” doesn’t mean the same thing for everyone. In particular, there’s a bit of confusion about what ideal householding would even look like, much less what it would take to get there. So, here it is, your guide to householding — everything you always wanted to know.¹

What is householding, anyway?

Householding is the joint management of multiple accounts to a common asset allocation. The accounts might all belong to one person—typically some combination of taxable accounts, Roth IRAs, traditional IRAs, trust accounts, and (harder, for practical reasons) 401(k)s. They may also belong to multiple people in the same household, like a husband and wife.

The goal is straightforward: manage the accounts in the household so that their combined holdings match a household-level target asset allocation. If one account is overweighted in an asset class, the other accounts need to collectively be underweighted to compensate. This is the heart of householding—jointly managing all the accounts to a shared target asset allocation.

The basic steps are simple:

• Compare the combined holdings of the household to the household-level target asset allocation.
• Note which asset classes are underweighted and which are overweighted.
• Sell the overweighted asset classes in one or more accounts and use the generated cash to buy
  the underweighted asset classes.

The first two steps are conceptually simple and completely automatable, though some firms lack systems to do it efficiently. (If that’s you, you might want to consider becoming concerned.)

The last step (selling overweights and buying underweights) can be a bit tricky if you can’t buy underweighted asset classes in an account where you need to sell an overweighted asset class. In principle, this may require a two-step solution, where, in order to sell A and buy B, you need to sell A and buy C in one account and then sell C and buy B in another. Fortunately, in practice, we don’t see this type of edge case very often.

A simple approach to the problem would be to just manage each individual account to this target allocation, so every account becomes a small copy of the whole (at least at an asset-class level; product will likely still differ). Mathematically, this works: if every account has the same household-level target asset allocation, then their combined holdings will, too. It’s even a reasonable approach if none of the accounts are taxable, in which case there’s no tax penalty for rebalancing each account back to its “mini-me” target.

But if any of the accounts are taxable, this mini-me strategy fails in the sense that it is tax-inefficient. Tax-efficient householding is where things get interesting.

What does “tax-efficient” householding mean?

Householding means jointly managing a group of accounts to a shared target asset allocation. Tax-optimized householding means doing this in the most tax-efficient way possible. There are six components:

• Avoid wash sales across household accounts. Wash sales can be triggered by transactions in different accounts in a household. Not doing this is the bare minimum of “tax managing” a household. It’s table stakes.
  
• Minimize realized capital gains (and transaction costs) by minimizing turnover at the household level. Suppose the combined holdings of the household match the household target exactly, but one account is overweighted in asset class A and another account is underweighted. If the account with the overweight is taxable, the tax-efficient solution is to do… nothing.
• When rebalancing at the household level, minimize tax on realized capital gains through strategic account selection. Suppose that the combined holdings in a household are overweighted in some asset class (and therefore, necessarily, underweighted in others). You’ve got to sell the asset class in one or more of your accounts, and you’ll want to do it in a way that minimizes taxes on realized gains. The way to do this is to preferentially:
  • sell in taxable accounts if you can do it at a loss.
  • then sell in qualified accounts, using them as tax-free household-level rebalancing centers.
  • then sell in whatever combination of taxable accounts minimizes tax on capital gains. Maybe this is done by doing all the selling in one account, maybe in another, maybe a combination of the two.

• Minimize tax on income through strategic asset location. Some types of income—like bond interest and short-term capital gains from high-turnover equity strategies—are taxed at higher rates than qualified dividends or long-term capital gains. You can reduce tax on income by preferentially placing these higher-taxed assets in qualified accounts. The canonical example: put the bonds in the Roth IRA.

• Continue managing each taxable account in a tax-optimized manner. All of the above steps are about avoiding tax on capital gains and income at the household level. There’s still old-fashioned account-level tax management—tax-loss harvesting, gains deferral, optimal tax lot selection, and wash sale avoidance.

• Be able to implement tax or gains budgets at the household level. Being able to implement gains budgets at the account level is fairly standard, but most clients don’t care about the tax they pay on any given account. They care about their total tax bill. So, ideally, tax budgets, if any, should be applied at the household level.

What makes householding hard?

Conceptually, nothing we’ve mentioned sounds too esoteric. In practice, some (most) firms struggle to do all of it consistently and well. Here are the main challenges firms face:

• Data aggregations. By definition, a household consists of multiple accounts. To implement householding, the holdings of these multiple accounts need to be (virtually) combined. Complicating things, holdings may be spread across multiple account types (e.g., taxable, trust, retirement), custodians (e.g., Schwab and Fidelity), and investors (e.g., husband and wife). Some accounts, like 401(k)s, may be controlled by third parties.
• Balancing competing optimization goals. Minimizing tax on income (asset location) can conflict with minimizing tax on realized capital gains, in two ways:

1. If you maximize asset location by loading up qualified accounts with bonds and the like (to minimize tax on income), so that they contain no other asset class, then you can’t then use the qualified accounts as tax-free asset-class rebalancing centers if, say, at the asset-class level, you need to sell equities.

2. If assets are currently in the “wrong” account—if, say, your bonds are all in taxable accounts—you may want to sell bonds in the taxable accounts and buy bonds in qualified accounts. But “selling bonds in the taxable accounts” may incur capital gains taxes, meaning you're facing a trade off between minimizing tax on future income vs minimizing tax on capital gains now.

• Adhering to account-level constraints. While the goal of householding may be to manage all the accounts in a household as a seamless whole, each account is its own separate entity that may have its own constraints. Most commonly, each account can have its own buy list, so buying, say, real estate won’t mean the same product in each account. And, as noted earlier, some asset classes may not even be available in all accounts (or, equivalently, you may not want to buy them in all asset classes—think buying muni bonds in a qualified account). You can also run into a constraint on how far each account’s asset allocation can deviate from the household-level target asset allocation. Advisors may be OK with some deviation, but are uncomfortable if the different accounts—especially those belonging to different people, like a husband and wife—are too different. (The concern is that this has the potential to cause trouble if the different holdings result in markedly different performance.)
• Adhering to household-level constraints. Household-level constraints are constraints that apply to the sum of all the accounts in the household. The two main such household-level constraints are wash-sale avoidance and adhering to gains budgets. Neither of these constraints can be achieved by looking at the individual accounts' isolation. You need a broader view.
• Simultaneous trade execution. The idea of householding is to get the combined holdings of all the accounts in a household to match the household-level target. This requires coordination, which requires that all the accounts be traded at roughly the same time. Otherwise, the account may—at least temporarily—veer from its household-level target or violate its household-level gains budget. This simultaneous trading can be tricky when accounts span multiple custodians, multiple investors and multiple platforms (e.g., RIA and bank trust).

Why now?

We mentioned at the beginning that we are seeing increased focus by RIAs and bank trusts on doing householding right. Which leads to the question: why now?

We think it’s part of a broader shift in the industry on the core value of wealth management—away from product, performance, and individual trades, and toward financial planning and serving as a lifetime coach for clients. In this context, competently implementing the basics of risk and tax management—very much including householding—becomes critical.

It’s also part of a bid by firms to increase their wallet share. If you can expertly manage households in a holistic manner, it’s in the client’s interest to consolidate all of their wealth management under one roof.

Another factor is a marked improvement in rebalancing technology. Until relatively recently, providing tax-optimized householding at scale simply wasn’t possible—so, as a practical matter, it wasn’t worth worrying about. That’s changed; technology (such as, well, ours now makes it possible to provide every client with sophisticated householding, if so desired, without any increase in operational complexity.

What is Smartleaf doing?

The above discussion is general; it’s not tied to our or anyone else’s specific technology. But we’re not bystanders here. Smartleaf’s mission is to make it possible for wealth advisors to deliver sophisticated, customized, tax-optimized portfolio management—at both the account and household level—to every investor of every size.

To this end, we support every aspect of householding described above. Specifically, we automate:

• Creating a household by joining accounts across individuals and across RIA custodians, bank trust systems
• Setting a household-level asset-allocation target
• Avoiding wash sales
• Implementing account location preferences
• Rebalancing at the household level in a tax-optimized manner
• We do this by preferentially selling at a loss in taxable accounts, then selling in qualified accounts, then selling in whatever combination of taxable accounts will minimize gains.
• We even handle the corner cases that require what we described as a “two step” solution, where in order to get to a “sell A, buy B” outcome, you sell A and buy C in one account and in sell C and buy B in another).
• Adhering to account-level constraints (e.g., buy lists and limits on maximum deviation from the household-level target asset allocation)

The only thing we don’t currently automate is “reallocation” of assets among household accounts, trading off the benefits of lower taxes on future income against current taxes (but we’re working on it).

And we do one thing more: we let users document, for each household, the amount of taxes they save or defer through their active household-level tax management, above and beyond what they save or defer through account-level tax management (which we also document).

Where does householding go from here?

As noted in the beginning, we’re seeing a big increase in interest by wealth managers in systematizing their delivery of tax-optimized householding. We think this will create a virtuous circle:as more firms adopt sophisticated householding, clients will come to expect it as standard practice. This, in turn, will drive further innovation in householding technology, resulting in better outcomes for clients and stronger retention for advisors. Tax-optimized householding will simply become the new norm.

The title of this post, especially the bit about being “afraid to ask”, is tongue in cheek. But there really is fear around householding – a fear of not being able to effectively deliver optimized householding at scale. Until recently, that fear was rational. No more. The technology to deliver optimized householding at scale now exists; there are simply no process barriers to tax optimized householding becoming the new norm.

Which may be the most important thing to know about householding.

¹ But were afraid to ask (with apologies for the mildly risque reference)