Asset allocation—an investor’s proportion of stocks, fixed-income investments, and cash—has been well documented to be the primary determinant of performance for broadly diversified portfolios. But performance in this case is often calculated on a pre-tax basis, when at the end of the day we, as individuals, must eat with after-tax dollars. So, when implementing an asset allocation plan, you should be mindful of the types of accounts (“pockets”) in which you purchase and hold various assets. For example, are all equities more suitable for taxable accounts? Are certain fixed-income instruments preferable in tax-deferred accounts? How about real estate exposure? In investment jargon, this decision-process is called asset location. By optimizing the location of one’s holdings, one may reduce a potentially significant cost that can erode returns over time—taxes.
It is common for investors to have multiple types of accounts, such as a combination of taxable portfolios and tax-deferred vehicles, such as IRAs and other retirement plans. For truly optimal asset location, you should view all of your investments as one portfolio, rather than as different accounts. This can be psychologically challenging at times, particularly if one is prone to comparing the performance of the various pieces. It may be perfectly appropriate to have a taxable account be more equities-oriented, yet it is still hard to watch it drop during a bear market, particularly when another, more income-oriented account is holding its ground. But focusing on the entire pie’s return, rather than the return of individual slices, could prove well worth the interim stomach churning.
Obviously, the value added by asset location depends on the mix of one’s taxable and tax-deferred assets, as well as on one’s tax bracket and time horizon, but there are some general, commonly accepted guidelines that have been affirmed by academic literature.1 The following discussion is based on the current tax structure, and needless to say, this can and likely will change. Even so, the discussion is worth having to better understand some of the issues to consider when seeking to optimize after-tax—and risk-adjusted—returns.
Taxable Accounts
By and large, equities are better suited for taxable accounts than for tax-deferred accounts. This is because gains on equities are taxed at capital gains rates, while interest on taxable bonds and other income-oriented assets may be subject to higher, ordinary income tax rates.2 While taxes on gains of appreciated securities held in tax-sheltered accounts can be deferred until mandatory distributions begin at age 73 (or age 75 for those born in1960 or later), they cannot be avoided. Appreciation in tax-deferred accounts is ultimately taxed at ordinary income tax rates when funds are distributed. Your contributions are too if they were made with pretax dollars.
Although income and dividends earned in taxable accounts are subject to taxes, investors can control when capital gains are realized, as taxes are owed only when and if the asset is sold. Another controllable factor is the ability to employ tax-efficient vehicles such as index funds, and particularly exchange-traded index funds, in taxable accounts, as discussed in more detail later. These vehicles tend to make minimal if any ongoing capital gains distributions—particularly distributions of less tax-efficient short-term capital gains.
Furthermore, most stock dividends (known as “qualified” dividends) enjoy a preferential tax rate—the same as long-term capital gains. Again, both components of stocks’ total return—capital gains and dividends—would ultimately be taxed at the higher, ordinary income rates upon distribution from a retirement account.
Losses, which we all know are part of equity ownership, can be useful if held in taxable accounts because if they are realized, they can offset realized capital gains. Any remaining net loss in a given year can be carried forward indefinitely for future offset, and up to $3,000 of capital loss can be applied against ordinary income annually. Losses realized within tax-sheltered retirement portfolios cannot be used for this purpose.
Owning equities in taxable portfolios can also be beneficial from an estate planning standpoint. Specifically, upon the death of the account owner, assets within a taxable portfolio generally receive a step up in cost basis. This is particularly advantageous for assets with relatively high appreciation potential, such as equities. Highly appreciated assets held within taxable accounts can also be given to charity during one’s lifetime, providing yet another planning benefit.
Despite these generalizations, it is important to note that not all equities, nor equity vehicles, are created equal. As explained below, there are instances in which it may make sense to have exposure to certain types of equities in a tax-deferred portfolio.
Tax-Deferred Accounts
In most cases, the shelf space in a tax-deferred portfolio should be used for the least tax-efficient asset classes. These would include taxable fixed-income instruments, given that most of their return comes in the form of ordinary income—that is, interest—instead of capital gains. Fixed-income instruments within this category include CDs, government agency debt, and taxable municipal bonds. Inflation-protected U.S. Treasuries—TIPs—should also be owned in tax-deferred accounts. Even though the inflation adjustment is not paid until the bond matures, this continual, non-cash accrual is treated as phantom income, which is subject to taxes if held outside a tax-deferred account. Nominal non-inflation-adjusted U.S. Treasuries, on the other hand, are more suitable for taxable portfolios, as their interest income is exempt from state and local taxes.
Outside of the fixed-income realm, real estate investment trusts (REITs) are also best held in tax-sheltered portfolios. REITs must pay out most of their earnings, and generally these dividends are taxed as ordinary income, rather than at the preferred 15 percent rate for most common stock dividends. And even though I do not typically recommend them, given that there has been a fair amount of debate as to whether they are a core asset class, commodities are also normally best held in tax-sheltered portfolios. Gains on commodities such as gold and silver are subject to their own collectibles tax rate, currently a maximum of 28 percent, instead of lower capital gains rates. Furthermore, many commodities funds use, and continually roll over, futures contracts, which can be relatively tax inefficient. One exception may be master limited partnerships (MLPs), many of which are in the pipeline business. Because depreciation and other expenses typically pass through to investors, MLPs are normally best held in taxable portfolios. Furthermore, income from MLPs may be considered “unrelated business taxable income,” which can prove to be onerous for tax-deferred accounts.
Finally, certain categories of investment vehicles are better suited for tax-deferred accounts. These would include actively managed funds, which generally have higher portfolio turnover and are thus more prone to taxable distributions.
The same holds true for certain types of equity index funds. For instance, one could argue that traditional, open-ended index mutual funds—which differ from exchange-traded index funds (ETFs)—are better suited for tax-sheltered portfolios. This is because, at least in theory, index mutual funds may be slightly less tax-efficient than index ETFs, because redemptions by mutual fund owners may force a fund to sell positions and thus potentially realize capital gains, whereas the sale of an ETF occurs over an exchange in the secondary market, or on an “in kind” basis for larger institutional investors.
Additionally, index funds that comprise smaller company stocks may be moderately less tax-efficient than large-company index funds. Small-cap indexes are more prone to changes in the underlying company holdings. Due to this turnover, they may be subject to a higher frequency of distributions. That said, most broad-based index or passive asset class funds across the market capitalization/company size spectrum are relatively tax-efficient, especially compared to actively managed funds.
A Special Case: Roth IRAs
There is one tax-sheltered retirement account in which it normally does make sense to focus on equities—Roth IRAs. These accounts are funded with after-tax dollars, as opposed to pretax dollars for traditional IRAs and other retirement accounts—but the money compounds on a tax-free basis thereafter. Thus, there is a strong incentive to take advantage of this shelf space for maximum growth. Of course, the decision to maintain equities in a Roth IRA should first be made within the context of one’s overall asset allocation. The same holds true with Roth 401(k) plans, which are also funded with after-tax dollars.
The tax-free growth afforded by Roth accounts can also be advantageous from an estate planning perspective. First, unlike traditional IRAs, they are not subject to required minimum distributions (RMDs) during the owner’s lifetime. And second, even though Roth accounts are included as part of one’s overall estate, and thus may be subject to estate taxes, and beneficiaries are required to take minimum distributions from inherited Roth accounts, these distributions are not subject to income tax.
Locating Cash for Spending
Equally important to the tax-efficient placement of assets is the strategic decision of selecting the appropriate accounts to draw from during retirement. Some types of accounts, namely traditional IRAs, and other retirement vehicles, have RMDs. However, for those who either are not yet taking RMDs or need funds in excess of this amount, the general guideline is to take funds out of taxable portfolios first. Again, the investor would pay the capital gains rate only on the appreciation of securities sold, as opposed to higher ordinary tax rates on the full amount distributed from an IRA. Traditional IRAs and other pretax-funded retirement vehicles would be next in line. Roth IRAs would be the last consideration—again, because of the tax-free compounding.
Of course, what would a general rule be without some worthy exceptions? For those with significant pretax IRA assets who are retired and over the age of 59½ yet are younger than age 73 and thus not subject to RMDs, it may make sense to draw from an IRA if one is temporarily in a low-income tax bracket. Once RMDs and/or Social Security benefits begin, they may be forced into a higher income tax bracket. Additionally, there may be estate planning benefits to tapping substantial IRAs and other pretax retirement assets early, as certain beneficiaries may be subject to both estate taxes and income taxes on their distributions (again, income taxes do not apply to Roth IRA distributions).
Playing Our Hand in an Uncertain World
Despite the importance of asset location, it bears reiterating that ultimately asset allocation, as well as one’s savings—and withdrawal rate/spending rate – are paramount. And obviously, any one investor’s ability to optimize his or her asset location is ultimately a function of the individual’s account structure. In other words, if most of your assets are in tax-sheltered retirement accounts, the point is relatively moot. Asset location is arguably also more relevant for younger investors, for whom cost and tax inefficiencies have a longer time to compound. Finally, as with all investing, the perfect asset location for anyone will be known only in hindsight, because tax policy is always in flux, as are one’s own personal financial circumstances and tax rates.
All of this said, investing “smart” means seeking to maximize your after-tax, risk-adjusted returns. Having an asset location framework can help you achieve this. Whether your financial empire consists of a few or many accounts, picking the right pockets can lead to more money in your pocket.
1A key study which continues to be widely cited is “Optimal Asset Allocation with Taxable and Tax-Deferred Investing,” by Robert Dammon, Chester Spatt, and Harold Zhang, published in the 2004 of The Journal of Finance. At the time, all three authors were financial academics/economists, and their paper won the 2004 TIAA-CREF Paul Samuelson Award.
2 It is important to note the distinction between federal short-term and long-term capital gains rates. Short-term capital gains are taxed as ordinary income; long-term rates, however, are lower – currently 0%, 15% or 20%, depending on one’s overall taxable income.
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