Does the 2003 tax law change how your retirement account should be invested?
Most investors have some of their money in tax-deferred accounts – such as IRAs and 401(k)s – and the rest in taxable accounts. When a portfolio is diversified, the investor has to decide which assets to purchase in a tax-deferred account and which in a taxable account. The decision affects after-tax returns, and that affects the amount of money available for retirement.
In the past I’ve debunked the traditional advice. That advice is to put highly-taxed, income-producing investments, such as bonds and high yield stocks, in the tax-deferred accounts. Tax-advantaged investments, such as stocks, should be put in taxable accounts.
The advice is logical. Interest on bonds is fully taxed as ordinary income. More of the interest could compound over the years if it were protected in the deferred account. Stocks, meanwhile, already get a tax benefit in the maximum long-term capital gains rate that was 20% and now is 15%. In addition, when capital gains are earned in an IRA, they are converted into ordinary income when distributed.
My research showed that the answer was not that simple, and that the traditional advice was wrong for most investors. Research by others eventually reached the same conclusion.
Here’s a brief summary of my conclusions before the 2003 tax law.
The best split of investments depended on the investor and his or her investment policy. The traditional advice worked best for an investor whose equity investments are individual stocks that are purchased and held for longer than one year. The advice also was good for an investor who owns equity mutual funds for longer than one year and the funds make small or no taxable distributions each year. That type of investor takes full advantage of the tax benefits of stocks and equity mutual funds in a taxable account.
Most investors do not fit that description.
Many investors sell stocks or mutual funds after owning them for less than one year. Other investors own funds that trade frequently, requiring them to make significant taxable distributions each year. In these cases, most of the gains from stocks are taxed as ordinary income and do not get the benefit of long-term capital gains rates. My research found that investors in these situations were better off with their higher-returning equity investments in tax deferred accounts. The tax deferral allowed more of the gains to compound over time than owning them in a taxable account would.
There were a couple of other factors to consider.
One factor was the difference between the investor’s ordinary income tax rate and the long-term capital gains rate. If there was a small difference, the allocation decision was not as important. Someone in the highest ordinary income tax bracket, however, would get a significant benefit from getting the allocation right.
The second factor was whether there would be any difference between the investor’s ordinary income tax rate during the accumulation years and during the retirement or distribution years. There often is no difference between pre-retirement and post-retirement tax rates these days. But someone who anticipates being in a lower tax bracket during retirement would benefit by putting the higher-returning investments in a tax deferred account.
Does the 2003 tax law change any of these conclusions or advice? The new law gives even more benefit to long-term capital gains by dropping the maximum rate to 15%, while the top ordinary income rate is only reduced to 35%. In addition, the top rate on dividends is reduced to 15%. That is a significant reduction. The 15% rate does not apply to dividends from real estate investment trusts.
Let’s take a look at how these changes affect investor Max Profits. Max has $200,000 that he plans to split evenly between stocks and bonds. His cash already is split evenly between taxable and tax deferred accounts. Max is an average mutual fund investor, so he assumes that because of trading and distributions 33% of his equity mutual fund returns in the taxable account are taxed annually at the 15% rate. Max expects to earn 9% annually from stocks for the long term and 4% from bonds. After 20 years Max will take annual distributions equal to $25,000 in today’s dollars, and he assumes 3% inflation. Initially, withdrawals will be from the taxable account.
I used the same computer program as in my past research and incorporated the new tax law. The capital gains tax rate was reduced to 15%, and Max was put in the 33% ordinary income tax bracket (the second highest bracket). (Under the new rates, Max’s money will last a couple of years longer than under the previous law, regardless of how it is invested.) Under the assumptions and the new law, Max’s money lasts a couple of years longer if the higher returning investments are put in the IRA instead of the taxable account. This is true though some long-term capital gains are converted to ordinary income.
The difference becomes even more dramatic if Max changes his investment policy. If Max puts the higher returning stock mutual funds in the taxable account and invests that account so that only 25% of the annual return is taxed at the 15% rate, Max’s money will last much longer. These results are in the graph.
Given these two choices, Max should invest in equity mutual funds in the taxable account and use tax-wise investment strategies in the taxable account.
Since many people expect lower stock returns in the future than in the recent past, I took a look at the results if the long-term return from stocks were 6%, and the bond return remains at 4%. The percentage of stock returns in the taxable account that were taxable each year remained at 25%. Under these circumstances, putting the higher returning stocks into the IRA would be a terrible choice. Max’s retirement accounts would be depleted much faster than under any of the other scenarios.
As a result of these studies, I’ve compiled the new rules for investing tax deferred and taxable accounts under the 2003 law:
Taxes count. Investors need to consider taxes when setting their investment policies and deciding how to split their investments between tax-advantaged and taxable accounts. Taking advantage of the tax breaks available in taxable accounts makes wealth last longer than shielding higher returns in a tax-deferred account.
The tax cuts help. Under any of the scenarios, the 2003 tax cut makes a retiree’s nest egg last at least a year or two longer than under the old law.
The IRA advantage is reduced. Higher-returning investments such as stocks and equity mutual funds are better in an IRA instead of a taxable account under fewer circumstances. The stock returns need to exceed the returns from bonds by more than a couple of percentage points annually for it to make sense to put stocks in the IRA. Also, stocks are better in an IRA only if the investment policy would result in more than 25% of the annual return from equities being taxed at ordinary income tax rates if they were invested in a taxable account.
Tax-wise investing can significantly preserve wealth. An investor gets the best results by maximizing use of the 15% tax rates for long-term capital gains and dividends. There are several ways to do this. You can purchase individual stocks and hold each for more than one year before selling. Or you can purchase equity mutual funds that use tax-wise investment policies. These funds should have low turnover and hold their stocks for longer than one year. High-yielding stocks and equity mutual funds also should be held in taxable accounts so that the dividends will be taxed at the 15% rate instead of the ordinary income tax rate.
Real estate investment trusts probably should be owned in tax deferred accounts. While REITs will have significant capital gains over time, they also pay high dividends that are not eligible for the 15% rate. The taxable portion of the dividends will be taxed as ordinary income.
Of course, don’t let taxes dictate your investment policy. For example, if the bulk of your portfolio is owned through a tax-advantaged account such as an IRA or 401(k), don’t use that as a reason not to buy stocks. First, determine the appropriate investment allocation for you. Second, decide how that portfolio should be divided between taxable and tax-advantaged accounts. If there isn’t enough money in your taxable accounts to buy all the stocks you should have, then buy the stocks in tax deferred accounts.