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

Which Investments For Tax-Deferred Accounts?


The tax law can make the simplest decisions difficult. For example, which investments should be put in your tax deferred accounts, and which in your taxable accounts? The answers might not be what you think.

A little over a year ago I challenged the conventional wisdom on how best to split your investments between taxable and tax deferred accounts. The conventional wisdom always has been that income-producing investments, such as bonds and high dividend-paying stocks, should be in tax deferred accounts, and stocks should be in taxable accounts. But I wanted to see what worked best for real world investors who sell their stocks and mutual funds from time to time and receive distributions every year from their mutual funds.

My real world examples found that the best approach depended on the type of investor you are. The conventional wisdom worked as planned for investors who bought stocks and held them for a long time or who held mutual funds that made very low annual distributions, such as index funds. But investors who tend to sell funds more frequently – especially before the one year holding period to get the long-term rate – were better off keeping their stocks in tax deferred accounts so that the gains could compound tax deferred. The rule for those investors was that your higher returning investments should be in tax-deferred accounts.

It is time to revisit the issue, because the tax law has changed. The long-term capital gains tax rate has dropped to 20% from 28%. That’s a sizable drop. In addition, the holding period to get that rate has increased to 18 months from 12 months.

What I found is that the traditional conventional wisdom works best for most investors now, especially for anyone in the 31% or higher tax bracket – even if each year your mutual funds distribute a portion of their gains and you sell some shares. Just be sure your sales qualify for the long-term capital gains rate. Stocks should be put in tax deferred accounts primarily when you trade frequently, incurring ordinary income taxes on the gains, and the stock returns are higher than your interest income.

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Suppose you have $20,000 split equally between an IRA and a taxable account. You will split your total portfolio equally between stock and bond funds. The stock funds distribute gains equal to 20% of their appreciation for the year. And you sell 25% of your shares each year, paying the long-term capital gains rate and reinvesting the proceeds in another fund. Let’s say that gives you a tax rate equal to about 10% of your total return for the year. The stocks earn 12% annually, and the bonds earn 6% interest. Your ordinary income is taxed at 31%.

The graph shows the after-tax values of two different portfolios. In one the bonds are in the tax deferred account, and the stocks are in the taxable account. In the other, the stocks are in the deferred account. The example assumes that only the income and gains in the tax deferred account will be taxed. If you made before tax contributions to the account, as with a deductible IRA or 401(k) account, all of the distribution would be taxable and you’ll have to factor that in along with investing the tax savings from the contributions.

Under last year’s tax rules, this investor probably would be better off putting the higher earning stocks in the deferred accounts, because there was not much of an advantage in the long-term capital gains rate. It was more important to put the higher-earning investments in tax deferred accounts. But now the tax advantage of long-term capital gains is much greater. Now, if most of the stock fund sales and distributions qualify for long-term capital gain treatment, the investor is better off putting the stocks in a taxable account and letting the interest income compound in the tax deferred account.

The higher your tax bracket, the more important it is to shelter your high-return stock investments by paying only the maximum 20% capital gain rate on your returns. But another factor to consider is the tax rate you’ll have when you take money out of the tax deferred account. There is a possibility that you’ll be in a much lower tax bracket at retirement, though I doubt you’ll be able to maintain your lifestyle in retirement in the 15% tax bracket if you are in the 31% or higher bracket today. But if you believe that your retirement tax bracket will be lower than today’s tax bracket, you could come out ahead by putting your highest returning investments in deferred accounts. You’ll be paying taxes at a much lower rate in the future when you withdraw the gains.

You shouldn’t let the tax rules determine your investments. But after determining how you want the portfolio allocated and which funds you want to buy, you can use the tax rules to decide which funds to buy in the taxable and tax deferred accounts. Make the best investment choices for you, and if you have flexibility choose the best tax mix by putting stocks in taxable accounts and income investments in tax deferred accounts.



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