Financial Advice for Retirement, Social Security, IRAs and Estate Planning

How to Put Investments in the Right Places?

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With today’s tricky tax law, the account in which you hold an asset can be as important as which assets you own. Unfortunately, too little attention is paid to the issue of which accounts should hold which investments.

Most of us have more than one type of investment account: 401(k)s, traditional IRAs, Roth IRAs, taxable accounts, perhaps others. Each of these accounts has very different tax rules, and after-tax returns are what count. The account in which an investment is held directly affects the after-tax money available for retirement.

I have done research on this issue over the years, and my results now are supported by other published research. But before considering specific assets and accounts, there are some general factors to consider.

One factor is the difference between the investor’s ordinary income tax rate and the long-term capital gains rate. If there is a small difference, the allocation decision is not as important. Despite the different tax rules on the accounts, the tax rates imposed on an investment will be similar regardless of the account in which it is held. Investors in the higher ordinary income tax brackets, however, face a significant gap between taxes on long-term capital gains and on ordinary income. Those taxpayers receive a significant benefit from getting the allocation right.

The second factor is 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. These days, there often is no difference between pre-retirement and post-retirement tax rates. But someone who anticipates being in a lower tax bracket during retirement could benefit by putting higher-returning, ordinary income tax investments in a tax deferred account during the accumulation years. Taxes at today’s higher rate would be deferred, and the income eventually would be taxed at a lower rate.

With those special cases taken care of, here is how the picture looks to the rest of us.

There are significant benefits to holding long-term capital gain assets – such as stocks and mutual funds – outside of tax-deferred accounts such as traditional IRAs and 401(k)s. When held in taxable accounts stocks, mutual funds, and other capital gain assets owned for longer than one year are taxed at only a 15% rate. In addition, the taxes on gains are deferred until the investments actually are sold. If the assets are held until death, the heirs get to increase the basis to its fair market value and avoid taxes on all gains during the original owner’s lifetime.

Another benefit arises when an investment loses value. The asset can be sold, and the loss can reduce taxes on capital gains or ordinary income.

When capital gain assets are held in a traditional IRA or a 401(k), there are no taxes as long as the assets are held in the account. Even when trades are made, taxes on the gains are deferred. But when the gains are distributed from the IRA, they are taxed as ordinary income. For a top-bracket taxpayer, that means a 15% long-term capital gains rate is converted into a 35% ordinary income tax rate.

If the investor trades stocks or mutual funds frequently, gains would be taxed at ordinary income rates in a taxable account. That investor probably benefits from holding the capital gain assets in the IRA. If the frequent-trading investor owns both income investments – such as bonds – and the stocks, the priority should be to own the stocks in the deferred account. That assumes that the stock returns are higher than the bond returns. When the investments face the same tax rates, the higher-returning investment should be in the deferred account so that it eventually will compound to the greater amount.

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But that is not the best solution.

Most investors should try to be tax efficient with their growth investments, such as stocks, equity mutual funds, commodities, and real estate. These investments should be owned for more than one year before being sold and preferably for several years. In addition, the mutual funds generally should be those that make low distributions in most years. That means actively managed funds should have low turnover in their portfolios. Index funds naturally have low turnover and low distributions.

When a tax-efficient investment strategy is used, the stocks and other growth investments should be owned in taxable accounts. Profitable investments should be held for more than one year before selling, preferably much longer. When an investment declines in value the investor should sell the investment so that the loss can reduce overall taxes.

Tax-inefficient investments should be held in deferred accounts. The most tax-inefficient mutual funds include those that own high-yield bonds, intermediate-term bonds, and utility stocks. Growth stock funds, especially mid-cap growth funds, also tend to be tax-inefficient. That is because these funds tend to have high turnover that results in high distributions most years.

The most tax-efficient mutual funds, according to a recent study by Morningstar, are real estate, small cap value, foreign small and mid-gap growth, and diversified emerging market funds.

Those are averages. Individual funds might be more or less efficient than their category averages.

Tax-deferred retirement accounts should hold bonds and other fixed-income investments, real estate investment trusts, traditional hedge funds, and tax-inefficient stock mutual funds. Tax-deferred accounts also should hold funds or stocks that are frequently traded.

Taxable accounts also should hold physical assets such as non-income-producing real estate, gold and other precious metals, and collectibles. Also held in taxable accounts should be individual stocks that will be held for the long term and tax-efficient mutual funds that will be held for the long term.

Because of the gap between capital gains and ordinary income tax rates and low stock market returns, it might not make sense for a high-bracket taxpayer to hold a tax-efficient stock fund, such as an index fund, inside a tax-deferred account.

You do not want taxes to completely determine your investment decisions. But the tax code makes the location of investments a more important decision than ever, and the type of account in which an investment is held has a great effect on after-tax returns.

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