- Bonds should be held in tax-deferred retirement accounts,
- Stocks, especially passively held stocks, should be held in taxable accounts.
- The exception is that any liquidity reserves (usually short-term fixed income held for emergencies and other short-term cash needs) should be held in taxable accounts.
- In Scenario 1, stocks are held in taxable accounts and bonds are held in tax-deferred retirement accounts—that is, Roth IRAs and qualified retirement accounts like the 401(k), 403(b), traditional (deductible) IRA, etc.
- In Scenario 2, bonds are held in taxable accounts and stocks are held in retirement accounts.
- Bonds and other fixed-income assets
- Real estate investment trusts
- Hedge funds
- Stock mutual funds, especially those that are tax-inefficient or that tend to generate short-term gains
- Tax-efficient stock mutual funds or individual stocks that will be bought and held for at least 10 years
- Non-income-producing real estate such as raw land
- Gold bullion and other precious metals/gems
- When saving for retirement, individuals should maximize contributions to Roth IRA and qualified retirement accounts like the 401(k);
- When managing stocks in taxable accounts, individuals should aggressively realize capital losses (that are large enough to offset transaction costs) and hold onto unrealized capital gains; and
- As a rule of thumb, when possible while attaining the desired asset allocation, individuals should place bonds, real estate investment trusts (REITs) and other assets whose returns are taxed at ordinary income tax rates in retirement accounts; passively managed stocks and stock funds, index funds or tax-efficient funds should be held in taxable accounts. An exception to this rule is that individuals should hold their liquidity reserves in taxable accounts.
- The existence of tax-favored savings vehicles such as the Roth IRA and qualified retirement accounts like the 401(k);
- The ability to use realized losses to offset capital gains and, if there are net losses, the ability to write off up to $3,000 a year against taxable income;
- The tax-deferral of unrealized capital gains;
- The step-up in basis at death; and
- The tax-exempt status of most charities.
Tax-Efficient Investing: Picking the Right Pocket for Your Assets
by William Reichenstein
In this instance, the pockets are either taxable or tax-deferred. And determining which of your assets goes into which type of pocket is a key to minimizing Uncle Sams grab.
This determination is often referred to as the asset-location decision, and it is the subject of my column this month, which is the last of a three-part series on tax-efficient investing.
Three basic principles guide the tax-efficient portfolio concept. My first two columns covered the first two principles:
Principle 1: When saving for retirement, individuals should maximize contributions to Roth IRA and qualified retirement accounts like the 401(k). This was the subject of my February 2005 column Tax-Efficient Investing and What It Means to Your Portfolio.
Principle 2: When managing stocks in taxable accounts, individuals should aggressively realize capital losses (that are large enough to offset transaction costs) and hold onto unrealized capital gains. This was the subject of my July 2005 column The Great Tax Fight: Managing Stocks in Taxable Accounts.
In this column, well take a look at the third principle of tax-efficient portfolio management, which governs the asset-location decision—which types of assets should go into your tax-deferred retirement accounts, and which should go into your taxable accounts.
The Asset-Location Decision
The asset-location decision refers to the decision of which account—taxable or tax-deferred—will hold the stock assets and which account will hold the bond assets, while attaining your desired asset allocation.
There are at least three features of the tax code that favor holding stocks instead of bonds in taxable accounts.
First, long-term capital gains are taxed at lower rates when realized in taxable accounts.
Second, because stocks are more volatile than bonds, the option to realize losses and let the government share the loss is more valuable when stocks are held in taxable accounts.
Third, the option to avoid capital gain taxes by awaiting the step-up in basis at death or giving the appreciated asset to charity instead of a cash contribution is more valuable when stocks are held in taxable accounts.
How do these features affect the asset-location decision?
As we shall see, an individual should follow these general guidelines:
A Closer Look
To better understand the rules, lets take a closer look at the issues, making some simplifying assumptions to illustrate the reasoning behind these asset-location guidelines.
Assume there are two assets—stocks and bonds—and two locations where the assets can be held—taxable accounts and tax-deferred retirement accounts. Well also assume that stock returns come primarily in the form of capital gains, taxed at the capital gain rate (where applicable) of 15% (even with dividends, the tax rate would still be 15%), and bond returns come primarily in the form of interest income, taxed at the ordinary income tax rate of 28%.
Table 1 shows two asset-location scenarios for several different types of investors:
|Table 1. The Asset-Location Decision for Investors With Various Stock Holding Periods|
|Asset Location||Exempt Investor*||Active Investor*||Trader*|
|Stocks in taxable accounts||0% tax rate||15% tax rate||28% tax rate|
|Bonds in retirement accounts||0% tax rate||0% tax rate||0% tax rate|
|Bonds in taxable accounts||28% tax rate||28% tax rate||28% tax rate|
|Stocks in retirement accounts||0% tax rate||0% tax rate||0% tax rate|
|* The Exempt Investor is exempt from capital gains taxes on taxable accounts, either because the asset will be donated to charity as an appreciated asset instead of a planned cash contribution, or held until death and passed on with a step-up in basis.The Active Investor buys and sells stocks that are held longer than one year. The Trader actively buys and sells stocks that are held less than one year.|
In my February article, I demonstrated that the aftertax value of assets in retirement accounts effectively grows tax-exempt. Thus, both bonds and stocks have an effective tax rate of 0% when held in retirement accounts. [Remember that we are talking about after-income-tax values here. When you put money in a taxable account, you are investing an amount that has already been taxed. When you put money in a tax-deferred retirement account such as a 401(k) plan or a tax-deductible IRA, you put in pre-income-tax money, and when you withdraw the money from the account, you pay income taxes on the amount that the pre-income-tax money has grown to. However, the effective tax rate on the aftertax equivalent of the pretax money you put in is 0%—in other words, your final tax bill is essentially the income taxes you would have owed upfront on your original investment compounded by your investment return. To better understand the mathematics of this, you may want to refer back to my original February article Tax-Efficient Investing and What It Means to Your Portfolio.]
Since assets held in retirement accounts effectively grow tax exempt, the key asset-location issue boils down to the tax treatment of the assets held in taxable accounts.
So now lets take a look at those.
When held in taxable accounts, bonds (essentially bond interest income) are taxed at the ordinary income tax rate, assumed here to be 28%, as shown in Table 1.
What about stocks?
As I explained in my July column, the tax treatment of stocks held in taxable accounts depends upon the investors stock holding style—the length of time stocks tend to be held.
Table 1 shows three stock holding styles—those of traders with typical stock holding periods of under one year, active stock investors who buy and sell actively but hold stocks for one year or longer, and exempt stock investors who pay no capital gains taxes. Lets take a look at the asset-location implications in Table 1 for the exempt investor.
As the name implies, an exempt investor has a 0% tax rate on stocks held in taxable accounts. How does an investor get away with a 0% capital gains rate? He either awaits the step-up in basis at death or gives the appreciated stock to charity instead of an already planned cash contribution.
Comparing scenarios 1 and 2 for the exempt investor: Within the taxable account, stocks would have a 0% tax rate while bonds would be taxed at 28%. Obviously for this investor, the optimal asset location is Scenario 1: Hold stocks in taxable accounts and bonds in retirement accounts. Moreover, the asset-location decision should be the most important to exempt investors, because the discrepancy between the two tax rates is greatest.
Not all investors are able to await the step-up in basis or want to give the appreciated stock to charity. Table 1 also presents the implications for investors with other stock management styles.
The active investor realizes gains as soon as they are eligible for preferential tax rates (i.e., in one year and one day) and pays taxes at the 15% capital gain tax rate. For the active investor, stocks held in the taxable account are taxed at 15%, while bonds held in taxable accounts are taxed at 28%. Obviously, it is better to pay taxes on stocks at 15% than bonds at 28%. So, the optimal asset-location is once again Scenario 1: Hold stocks in taxable accounts and bonds in retirement accounts.
Some investors fall into the passive stock investment category. The passive investor buys and holds stocks until the end of the investment horizon and then realizes the capital gains and pays taxes at 15%. The passive investor is not shown in Table 1 but falls between the exempt investor and the active investor. The active investor pays an effective tax rate of 15% on stocks held in taxable accounts, while the exempt investor has an effective tax rate of 0%; the effective tax rate is less than 15% for the passive investor with a multi-year horizon. The longer the investment horizon, the lower the effective tax rate is. Passive investors also should favor Scenario 1, holding bonds in tax-sheltered retirement accounts.
Traders sell stocks so quickly that all gains are realized as short-term gains that are taxable at the 28% ordinary income tax rate. The asset-location decision should make no difference to a trader since he pays ordinary income tax rates on both bond and stock returns in taxable accounts—in other words, Scenarios 1 and 2 are equivalent. [In my opinion, these investors should seriously consider changing their stock holding style, and if they do, they should locate stocks in taxable accounts.]
From this reasoned analysis, it should be clear that the importance of the asset-location decision increases with the spread between the ordinary income tax rate and the effective tax rate on capital gains.
This spread is wider for high-tax-bracket investors.
It is also wider the more passive the investors stock holding style. So the more you are able to decrease your capital gains rate, the more important it is to locate your assets in the right account.
Accounting for Risk and Losses
A particularly astute reader may suggest that the higher returns on stocks may more than offset the difference in tax rates. For example, suppose stocks are expected to earn 8%, all capital gains, while bonds are expected to earn 4%. For an active investor, the 1.2% (or 15% of 8%) tax savings from sheltering stocks in retirement accounts exceeds the 1.12% (or 28% of 4%) tax savings from sheltering bonds. This seems to suggest that it may be better to hold stocks in retirement accounts since it may save more in taxes.
However, this argument only looks at the effect of asset location on assets expected returns or, to be more precise, the loss in returns due to taxes. The asset-location decision, though, also affects the risks of stocks and bonds borne by investors.
Risk typically is measured in terms of the volatility of returns. In taxable accounts, the governments tax bite affects the aftertax returns of both stocks and bonds, and thus also their volatility. Ironically, because taxes take a bigger chunk out of bond returns, the government in effect reduces risk more for bonds than for stocks in taxable accounts. The proper approach is to consider the effect of the asset-location decision on both risk and returns.
This leads to a very complicated analysis, which has been the subject of a number of studies that rely on mean-variance optimization, a tool that considers the effects of asset location on both assets risks and returns. In two recent mean-variance optimization studies that have been published in major research publications (including one of my own), the across-the-board conclusion is that all investors except traders should locate stocks in taxable accounts and bonds in retirement accounts; traders should be indifferent to the asset-location decision. [If you want to look at these studies, they are referenced in the References box.]
We can generalize these results to include assets besides stocks and bonds.
Table 2 presents pecking orders for assets held in retirement accounts and taxable accounts.
|Table 2. Pecking Orders of Assets for Retirement Accounts and Taxable Accounts|
The first asset to place in retirement accounts is bonds, followed closely by REITs. (real estate investment trusts) REITs pay large cash dividends that, unlike dividends on other assets, are taxed at ordinary income tax rates.
The third choice may be hedge funds, since returns on many hedge funds come from short-term gains that are taxed at ordinary income tax rates. (I discuss my concerns with hedge funds in What Are You Really Getting When You Invest in a Hedge Fund?, in the July 2004 issue of AAII Journal.)
The next choice for assets in retirement accounts would be tax-inefficient stock funds, which include most actively managed stock funds. The most tax-inefficient funds are those that realize capital gains quickly, especially those that realize substantial short-term capital gains. If you have both tax-efficient stock funds (such as most index funds, exchanged-traded funds, and tax-managed funds) and tax-inefficient stock funds (like most active funds), it is better to hold the tax-inefficient stock funds in a retirement account and the tax-efficient funds in the taxable account.
To understand the best assets to place in taxable accounts, recall that the importance of the asset-location decision increases with the spread between the ordinary income tax rate and the effective tax rate on capital gains. This spread is maximized when the effective rate on capital gains is zero—that is, for the exempt investor. Therefore, the first assets to place in taxable accounts are assets you never intend to sell or will give to charity as an appreciated asset, and passively held stocks and other assets that are expected to provide substantial long-term capital gain potential. The key is that you want to let capital gains grow unharvested for long horizons. The stocks can be tax-efficient stock funds that realize (and thus distribute) minimal capital gains, or individual stocks that you will passively hold for at least a decade. Other good candidates include tax-managed stock funds and index funds or exchange-traded funds that track a large-cap or total market stock index.
Raw real estate that will be bought and held for long horizons would also be a good asset to hold in taxable accounts, as would gold bullion (remember, though, I am not recommending these as investments—Im just suggesting where to locate them if you want to own them).
Although not optimal, it is better to hold actively managed stock funds—especially those that realize minimal short-term capital gains—rather than bonds or bond funds, in taxable accounts. The next asset should be whatever asset is needed to satisfy your asset allocation that cannot be held in a retirement account.
Will the Rules Hold?
Over this last year, my columns have discussed in detail the principles of tax-efficient investing. Stated succinctly, these principles are:
Based on existing legislation, contribution limits to Roth IRAs and qualified retirement accounts such as 401(k) and 403(b) accounts are scheduled to change almost yearly through 2010, but these accounts should continue to exist. Although Congress may introduce new savings vehicles and change contribution limits to existing vehicles, I am virtually certain that Roth-like and 401(k)-like retirement accounts will remain part of the Tax Code. In fact, due to the low savings rates in the U.S., it seems likely that Congress will increase opportunities to save in these most tax-advantaged savings vehicles.
I have not heard of any proposal to impose more restrictive provisions against investors ability to use realized losses to offset capital gains. Losses should continue to be used to offset gains. Moreover, the most recent round of legislation proposed allowing individuals to write off more than the current limit of $3,000 a year against taxable income. So this provision appears safe.
I have not heard of any proposal to deny investors the ability to defer taxes on unrealized gains. So this provision appears safe.
The final two provisions relate to the step-up in basis at death and the ability to deduct charitable contributions. Although there are some limitations to the use of these provisions, they apply to few individuals. Existing legislation is scheduled to limit the step-up in basis for people who die in 2010 to $1.3 million plus an additional $3 million for property going to a surviving spouse. This limitation will sunset after December 2010. Even if the $4.3 million limit including property going to a spouse is extended beyond 2010, few people should be affected. The charitable deduction of capital gain property is limited to 30% of adjusted gross income (AGI is the top number on page 2 of IRS Form 1040). For high-income individuals, this limit may be further reduced due to limits on itemized deductions. However, few should be affected by limitations on their ability to deduct charitable contributions.
In short, the three principles of tax-efficient investing discussed in this series of articles should remain viable strategies for the foreseeable future.
Although there are many topics related to tax-efficient investing that were not covered in these articles, the principles discussed here represent a good start toward becoming a tax-efficient investor.
Dammon, Robert M., Chester S. Spatt, and Harold H. Zhang, Optimal Asset Location and Allocation With Taxable and Tax-Deferred Investing, Journal of Finance, June 2004, pgs. 999-1037.
Reichenstein, William, Asset Allocation and Asset Location Decisions Revisited, Journal of Wealth Management, Summer 2001, pgs. 16-26.
William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University, Waco, Texas. He may be reached at Bill_Reichenstein@baylor.edu.