Picking the Right Tax Pocket for Your Assets

One big advantage of a 401(k) plan is that it is tax-advantaged—it helps minimize the amount of money Uncle Sam can grab from your pockets in the form of taxes.

But the best way to limit Uncle Sam’s reach is to make sure you are putting the right assets in the right pocket. In this instance, the pockets are either taxable savings accounts or tax-deferred 401(k) accounts.

The decision as to which account—taxable or tax-deferred—will hold your stock assets and which will hold your fixed-income assets while attaining your desired asset allocation is often referred to as the "asset location" decision. If you are just starting out and have savings only in your 401(k) plan, the decision is relatively easy.

But sooner or later you will be saving in both taxable and tax-deferred accounts. In this situation, your first decision, as always, is your asset allocation decision—the percentage of your total savings that you invest in the various asset categories.

But your next decision is where to locate these assets. Part of this will be a function of the choices available to you in your 401(k) plan. But assuming unlimited choices, how do you decide where to locate your assets? There are three features of the tax code that favor holding certain assets over others in taxable accounts.

• First, long-term capital gains are taxed at lower rates when realized in taxable accounts;
• Second, losses can be realized and the government can share the loss in taxable accounts;
• Third, capital gains taxes can be avoided by awaiting the step-up in basis at death or giving the appreciated asset to charity instead of a cash contribution in taxable accounts.

These tax code features tend to favor the placement of assets that generate return in the form of long-term capital gains (and the longer, the better) in the taxable account, and those that tend to generate primarily income in the retirement accounts.

Here is a break down for specific investments. But remember, it is only a list of where to locate assets if you have already decided to invest in that type of asset.

401(k) Plans and Other Tax-Deferred Retirement Accounts

The first asset to place in retirement accounts is bonds, which tend to generate returns that are almost entirely taxed as income. 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 where it is readily available. The next choice for assets in retirement accounts are REITs (real estate investment trusts), which pay large cash dividends that, unlike dividends on other assets, are taxed at ordinary income tax rates.

Tax-inefficient stock funds come next in the retirement account pocket, and these 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.

Taxable Accounts

The first assets to place in taxable accounts are assets you never intend to sell or that you 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 unrealized for long horizons. The stocks can be tax-efficient stock mutual funds that realize (and thus distribute) minimal capital gains, such as index funds, or individual stocks that you will passively hold for at least a decade. Other good candidates include tax-managed stock mutual 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, these are not investment recommendations, they are simply suggestions on 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 last asset in the taxable pocket should be whatever asset is needed to satisfy your asset allocation that cannot be held in a retirement account.