Most of you invest through both tax-deferred accounts (such as IRAs) and taxable accounts. You also own both stock and bond investments. To maximize after-tax returns, you want to know which investments should be primarily in the taxable accounts and which in the tax-deferred accounts.
First, don’t let the taxes drive your portfolio allocation. Decide how you want the portfolio split between stocks and bonds (and other investments) based on your needs, goals, investment forecast, and risk tolerance. Then, invest your taxable and tax-deferred accounts in the most tax-efficient way that is consistent with your allocation.
Now, let’s look at what the most tax-efficient way might be.
There are a lot of general rules floating around based on theory. These general rules are contradictory, yet each seems equally logical. Some say that stocks (including stock mutual funds) never should be in tax-deferred accounts. That is because all distributions from tax-deferred accounts are taxed as ordinary income with rates up to 39.6%. But stocks held in taxable accounts can qualify for the lower long-term capital gain rate of 20%. Others say that because stocks can earn higher returns, you are better off having those returns compound tax-deferred for years even if it means paying the highest tax rate on final distributions.
The only way to decide is to look at real numbers.
The graph shows the after-tax value of two portfolios over 30 years, each invested half in stocks and half in bonds. One portfolio puts the stocks in a taxable account and the bonds in a tax-deferred account. The other does the reverse. The assumptions are that the stocks return 10% annually; 4% of the value is realized as long-term capital gains each year and 4% as dividends or short-term capital gains. The bonds yield 6%. The long-term capital gains tax rate is 20%, and ordinary income is taxed at 31%. You can see in the graph that after-tax returns clearly are higher when the stocks are in the tax-deferred account.
But let’s focus on the assumptions before drawing any conclusions and general rules from this.
The assumed equity investments are tax inefficient. Each year 40% of the total return is taxable as long-term capital gains. Another 40% is taxable as dividends or short-term capital gains.
But suppose the owner invests more tax efficiently, say in index funds or other mutual funds that don’t distribute much of their gains each year. Or the investor purchases individual stocks and holds them for several years before selling.
If the portion of the return that is taxable each year is cut in half, the advantage of putting the equities in the tax-deferred account is much smaller. Only after 15 years does the tax-compounding of the higher return on equities make up for the higher taxes on withdrawal from the tax-exempt account.
Suppose now that the equity investments become really efficient. Suppose the investor holds individual stocks for a long time or invests in mutual fund that do so. Then the advantage swings decisively to putting equities in the taxable account. The more tax-efficient the equity investing, the more sense it makes to put the equities in the taxable account and capture the 20% long-term capital gains rate. Let the bond interest compound tax-deferred until it is withdrawn and taxed at ordinary income rates.
As in classes during my law school days, one question leads to additional questions before we can get an answer or draw conclusions. Before deciding whether to put equities in a taxable or tax-exempt account, examine what type of equity investor you are.
If you will buy individual stocks, hold them for the long-term, and take losses to offset any realized gains, then you are a tax-efficient equity investor. Your equity investments will be better off in a taxable account. Likewise, if you invest in mutual funds for the long-term that make low annual distributions of gains, and distribute primarily long-term capital gains, the equities probably will be better off in a taxable account.
But if you sell mutual funds or stocks after less than a year, or invest in mutual funds that trade a lot and distribute a large portion of their gains each year, your equities probably should be in the tax-deferred account. The length of time you will keep the funds in the account also is a factor. If the money will compound for 15 years or more and the equity investments are tax inefficient, they probably should be in a tax-deferred account. But if the equities won’t be in the account for long before you spend the money, they probably should be in a taxable account, or it doesn’t matter.
Suppose your time horizon is very long. You don’t plan to spend most of the money during your lifetime. Instead, it will be left for your heirs. Under current law, if the investments are inherited through a taxable account, your heirs get to increase the tax basis in the equities to their new fair market value. No one pays taxes on the capital gains accrued your lifetime. But if an IRA is inherited, the tax basis is not increased. All the gains during your lifetime are taxed as ordinary income to your heirs.
Don’t fall for theories or rules of thumb. Instead, take these examples, decide which type of investor you will be, and divide investments between taxable and tax-exempt accounts accordingly.