In deciding where to “locate” investments – in taxable vs. tax-advantaged accounts – investors often consider one of three approaches, which in reality are not mutually exclusive. The key is to strike a balance. At LNWM, we often use a combination of these approaches to optimize each portfolio, after-tax (see Part I for all the variables involved).
Place tax-inefficient assets, such as bonds and REITs, in tax-advantaged accounts, such as IRAs. What this usually means is that your taxable accounts would contain mostly high growth/low-income assets like stocks. And your tax-advantaged retirement accounts would hold the income-oriented assets like bonds, REITs, etc.
This advice makes sense in many cases. But it’s definitely not for everyone at all times. For instance, it may make more sense for a young person’s retirement accounts to contain high-growth assets. The investment horizon of someone in their 20s, for example, could be 75+ years, including the time the owner’s child beneficiary could own the account. Over this long a period, not paying taxes on dividends and capital gains creates a tremendous tailwind for growth.
Set the asset allocations within the taxable and tax-advantaged accounts, based on your situation, including investment horizon, liquidity needs and relative size of accounts, among other factors. For example, someone with taxable account(s) and a Roth IRA may decide to hold 80% aggressive growth stocks/20% bonds in the Roth IRA because she wants to maximize growth in an account that is tax-free. Assuming she won’t use this money for living expenses and wants the account to pass on to her children, short-term volatility is not a concern.
Begin with all your accounts invested similarly (say 60% stocks, 40% bonds), but once the strategy is implemented, trading occurs only in the tax-advantaged accounts. This limits the amount of realized capital gains (and thus taxes) within the taxable account. But in time, the asset allocation for each account may diverge dramatically and not be aligned with your overall strategy. So vigilance is required.
Thinking Outside the Box
Required Minimum Distributions (RMDs) starting at age 70 ½. Because of RMDs, retirement accounts begin to generate tax bills. So there’s a sea change in how these accounts should be managed, usually starting in your 50s or 60s. Since all withdrawals from traditional IRAs and most pension plans are taxed as ordinary income, many people with upcoming RMDs decide to limit growth assets in their retirement accounts. Otherwise, they could be hit with large payouts that bump them into a higher tax bracket.
Price volatility in traditional IRAs. If your IRA is invested mostly in stocks, chances are it will decrease in value substantially at some point due to market declines. Such bear markets, which so far have proven to be temporary, present an opportunity to convert IRAs to Roth IRAs. The amount of tax you pay to convert is based on the market value at the time of the conversion. Converting “near the bottom” means you pay less to convert to a Roth IRA, which can then grow tax-free, with no RMDs and no tax on withdrawals.
Growth-stock index funds in taxable accounts. Index funds of large U.S. stocks, such as the S&P 500, make sense in taxable accounts because they’re tax-efficient on an annual basis. But there are other good reasons to locate such funds in taxable accounts.
1. Tax-loss harvesting. Taxable accounts allow you to write off losses, and U.S. large cap index funds can be easily replaced later if you sell. Holding these investments mostly in your taxable account allows for efficient loss harvesting when the equity markets head south.
2. Charitable giving. Growth assets such as large-stock index funds can be good candidates for charitable giving because gains are not taxed when shares are given directly to charity.
Always start with the most appropriate overall asset allocation. The most effective asset location strategy comes AFTER — and is based on — your asset allocation strategy optimized for risk and return — and choice of investments. Only after those decisions are made should you decide which investments to put in each type of account.
No one asset-location approach works for all people all the time. And asset location strategies are not necessarily right for everyone. The extent to which we execute aspects of an asset-location strategy depends on each client’s unique circumstances.
For asset-location strategies to be the most effective, a long-term focus is crucial. Success or failure should be evaluated over the short and long term. Sudden changes in strategy at just the wrong time can do away with years of accrued tax advantages.
At LNWM, we know that tax-aware investing and asset-location strategies are dynamic. Clients change, cash needs change, target asset allocations change, investments change, and tax laws change. Because of this, we believe that approaching asset location in moderation is the smart approach.