Some people do all of their investing in an employer-sponsored retirement plan where earnings are untaxed until withdrawn, and perhaps in an IRA as well. Withdrawals are generally taxed at ordinary income rates, which now go up to 39.6%.
Conversely, others have taxable accounts as well; each year, income tax is due on investment interest, dividends, and net capital gains in these taxable accounts. Some dividends and gains qualify for favorable rates, currently no higher than 20%. (Taxpayers who are subject to the 3.8% surtax on net investment income might actually owe 23.8%.)
Therefore, investors with a foot on both sides of the tax-now-or-tax-later line must make some decisions about their savings and investments. Which types of assets go into tax-deferred territory and which assets work better in taxable accounts? Making informed decisions can help you substantially in long-term results from your investments after tax.
Financial advisers and investment managers may have differing preferences in this area. Stocks inside retirement accounts and bonds outside? Bonds inside and stocks outside? There are no universal rules to follow and there are many factors to consider when making decisions about asset location. The “correct” mix may vary from investor to investor. Nevertheless, some basic principles can help you in this decision.
Emergency funds should be held in taxable accounts where you can reach them if the money is needed. That’s also the case if you’re saving for a major outlay, such as a home purchase or higher education. With the money in a taxable account, you can access the funds without owing ordinary income tax or worrying about a 10% early withdrawal penalty before age 59½.
Historically, liquid dollars were often held in bank accounts and money market funds. Yields on these instruments are so low now that investors may be using short-term bond funds or something similar to get some return on their money. Even so, if you are holding assets for use in emergencies or for an anticipated expense, they probably should be in a taxable account.
If you’re saving for retirement in a 401(k) or similar plan, you’ll be limited to the menu options presented to plan participants. Therefore, if your investment plan calls for an allocation to precious metals, you may have to use a taxable account for a fund that holds mining stocks, say, or a gold bullion ETF. The same could be true if you want to own an emerging markets bond fund or a small company growth fund, if no acceptable option in these categories is on your plan’s menu.
Note that you can hold virtually anything in an IRA (except for life insurance and certain collectibles). Thus, your IRA could be used for hard-to-find assets.
Assuming that liquidity and availability are not concerns, tax treatment will drive the decision about where to hold specific assets. One aspect to consider is the expected return of an investment. The lower that return, the lower the annual tax bill, and the smaller the advantage of deferring that tax. On the other hand, deferring large amounts of tax each year may be a good reason for using a tax-deferred account for a given asset.
Example 1: Martin Miller’s asset allocation includes a high-quality corporate bond fund, now yielding around 2%. The fund seldom distributes capital gains to investors, so Martin expects to owe tax on that 2% payout this year and in succeeding years. In his 25% tax bracket, Martin would save 0.5% of his investment (25% bracket times the 2% yield) per year. That much tax deferral might not be enough to warrant holding the fund in a tax-deferred plan, so a taxable account could be the better choice.
Suppose that Martin’s asset allocation also includes a high-yield corporate bond fund, now yielding 5%, which has a history of distributing taxable gains to shareholders. In his 25% tax bracket, Martin can expect to save 1.25% or more in tax each year. This fund could be a better choice for his tax-deferred retirement account.
As mentioned, municipal bonds and muni funds often generate no income tax, so they are very tax efficient, whereas high-yield bond funds might generate steep annual tax bills, making them tax inefficient. As a general rule, you should try to hold assets with the least tax efficiency in your tax-deferred retirement plan.
Example 2: Phil Grant has an asset allocation that includes stock market index funds and funds that hold real estate investment trusts (REITs). Equity index funds tend to be tax efficient because they may have modest dividend payouts and seldom generate taxable gains, so Phil holds these funds in his taxable account. REIT funds may be tax inefficient, with relatively high dividends that might be fully taxable, as ordinary income. Phil puts his REIT funds into his tax-deferred account to avoid the annual tax bite.
Our office can go over the tax efficiency of investments you’re considering to help you decide on the best location. As the saying goes, you shouldn’t let the tax tail wag the investment dog. If you have a plan regarding which investments will help you attain your goals, you can get an added return when you know where to hold them.
Tracking Tax Efficiency
- An investment’s tax efficiency can be measured by its tax efficiency ratio. This shows how much of an investment return the investor keeps after taxes: after-tax return divided by pre-tax return.
- Say Jim Jones invests $100,000 in ABC Corp. stock. The stock produces an annual return of $10,000 and generates $2,000 in tax.
- ABC has a tax efficiency ratio of 80% ($8,000 after-tax divided by $10,000 pre-tax).