Regular readers know that I have assets held in taxable and non-taxable accounts.
Taxable account provide me with more flexibility in the range of investments I can select, and ease of accessing my money at a moments notice. However, I have to pay taxes on dividends and realized capital gains.
Non-taxable accounts ( also referred to as tax-deferred or retirement accounts) allow me to defer paying taxes on investments I have made. These retirement accounts come in all shapes and forms, but generally they allow me to defer paying taxes anywhere from a few decades to indefinitely. Taking money out of them is generally more difficult. It is not impossible however, and worth it, if you are willing to do some planning that will shave years off your journey towards financial independence. This is also not an issue for me, because I am a long-term investor and my investment money is not going to all be needed in a lump sum right away.
At the end of last week, Bruce Greenwald, the founding director of the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, sat down for a Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital as part of the 13th Columbia China Business Conference. The chat spanned many different topics, Read More
I have started to ask myself how to optimize my portfolio better. Deciding which assets belong in taxable accounts, and which belong in retirement accounts is one decision that would help me achieve a more optimized result (translation: more money). I want to make sure I am making the best long term asset placement for my portfolio.
There are various things to consider. This makes the decision relative, and not absolute. To make your decision, you want to be able to determine the limitations that each account has for you. You also want to determine the amount and timing of taxable liabilities that your assets will generate. You also want to determine the complexity that you are willing to tolerate at tax time. Learning a few simple tax tricks is worth it for me, since it cuts down on the time I would need to spend in a cubicle.
Let’s take this a little further. The two asset classes most commonly held by investors are stocks and bonds. Each asset class has its own distinct features, that will trigger the three decision questions above.
Stocks usually pay dividends and offer a higher opportunity for capital gains. They are taxed at advantaged tax rates for dividends and capital gains. The expectation is that equities offer a lot of opportunity to compound your capital and income over time. Dividends are taxed each year in taxable accounts, but capital gains and losses affect taxes only when they are realized. The top rate for dividends and capital gains is 23.80%. If you are in the 15% tax bracket, your dividend and capital gains are not taxable at the Federal Level.
If you never sell, your beneficiaries receive a stepped up cost basis, which eliminates the deferred tax liability stemming from unrealized capital gains on your stocks.
On other hand, if you have losses, those can generate tax write offs in taxable accounts. Unfortunately, you cannot deduct losses in your retirement accounts.
I own equities in order to grow my dividend income and net worth in real dollars over the long run. This should hopefully be a lifelong relationship with this asset class for me.
Fixed income on the other hand includes treasury bonds, or CD’s, are unlikely to deliver losses to you if held to maturity. But their interest is taxable as ordinary income every year.
The return on fixed income held to maturity is dependent on the starting yield at which you bought it. If you invest in bond funds however, you may experience losses in principal, since most of those funds never mature. This is why I prefer to buy individual bonds and CD’s, because I have control over the amount and timing of coupon payments, and I can control the timing for the return of principal. If I sell an individual bond prior to maturity however, I may experience gains or losses, depending on the movement of interest rates since I bought the security. I do not expect to sell my bonds, which is why I ladder them. In other words, I have a set amount of bonds and CD’s that will expire each month over the course of a five year period. I simply roll this forward automatically. (this is still a work in progress at the time of this writing)
I own bonds as an anchor, that will provide protection in the event of a deflation. I keep my emergency fund invested in fixed income. I also keep savings in fixed income for large ticket future expenditures that are to occur within the next five years ( e.g. – downpayment for a house, paying for college, or buying a car). Fixed income provides me with a source of liquidity that has a higher amount of certainty as to amount and timing, relative to dividend income or capital gains ( particularly when we are talking about CD’s and Treasury Bonds, not as much if we are talking about municipal bonds, corporate bonds, foreign bonds)
The other thing to consider are limitations on retirement accounts.
For example, pass through entities such as Master Limited Partnerships are difficult to hold in an IRA. Some brokers such as Fidelity and Sharebuilder do not allow purchasing MLPs in their retirement accounts. Therefore, investors should likely own those in taxable accounts.
You also want to consider the type of retirement account you are eligible for. Other retirement accounts only allow certain types of investments to be held there. For example, my workplace 401 (k) plan only allows me to own stock funds, bond funds, as well as some target date funds. Therefore, I cannot buy individual bonds to hold to maturity there.
In another example, US investors in foreign equities need to be careful about dividend tax withholdings in their asset placement strategies. Many foreign governments withhold taxes on dividend income at the source. US investors can claim a credit on their federal taxes if they paid foreign taxes on dividends on foreign stocks held in taxable accounts. US investors cannot claim credit for withholding taxes on dividends on foreign stocks held in tax-deferred accounts. As a rule, it makes sense to hold most foreign stocks such as Swiss food conglomerate Nestle (NSRGY) in taxable accounts. However, there are exceptions to the rule. For example, dividends on Canadian stocks that are held in retirement accounts do not face a withholding tax. In another example, dividends on UK based companies are not subject to any withholding taxes to US investors. Therefore, they could be held in taxable or tax-deferred accounts.
In order to illustrate the importance of placing the right assets in taxable versus non-taxable accounts I decided to run a simulation. You want to consider the best outcome for you.
I assumed that we have an investor who has $200 to invest. Half of the money can be placed in a taxable account, while the other $100 can be invested through a retirement account.
The investor has a holding period of 30 years.
This investor wants to have a 50% allocation to equities and a 50% allocation to fixed income.
Equities yield 3% and grow earnings and dividends at a rate of 3%. Therefore, I assumed that stock prices will grow a 3%/year. As a result, the total return would be 6%/year.
I assumed that the bond will yield 3%/year and will be held to maturity.
The investor has a marginal tax rate of 25% on ordinary income, and no state income tax. Therefore, they would pay a 15% tax on dividend income. I make assumptions that they are a long-term investor, which means they will not sell any stocks or bonds during the 30 year time period. The annual drag of taxes reduces the total return on equities from 6%/year to 5.55%/year in taxable accounts. The annual drag of taxes reduces the total return on fixed income to 2.25%/year in taxable accounts.
For the sake of simplicity I assumed that this retirement account is a Roth IRA. Since we are comparing relative advantage versus absolute advantage, we will get the same end result whether we use IRA or Health Savings Accounts (HSA’s).
The results are evident below. You can see that $100 invested in stocks was worth $574 in the retirement account after 30 years. The same amount invested in fixed income was worth $242.73 in the retirement account.
With taxable accounts, the equity amount is $505, while the fixed income amount is $194.94.
The investor who put his fixed income in the tax deferred account, and the stocks in taxable accounts, ended up with $748.26 after 30 years
The investor who put his fixed income in taxable account, and the stocks in tax deferred account, ended up with $769.29 after 30 years.
You can view the calculations at the following spreadsheet.
The overall conclusion is that you want to place the assets with the highest expected returns in tax deferred accounts. It may not make sense to lose valuable retirement account space by placing low return and tax inefficient assets such as bonds in them. This is a good observation to make, because the traditional advice has mostly focused on the tax liability portion of the equation, without looking at the problem from a more big picture perspective.
As a result of this exercise, I am considering holding a larger portion of my fixed income in taxable accounts.
But what if interest rates increase from here?
I re-ran the simulation, with the same tax rates, initial amounts, limits on retirement amounts and time periods. The return expectations on equities were the same at 6%/year. However, I increased the return expectations on fixed income to 6%/year as well. This reduced the annual return on taxable fixed income investments to 4.50%/year, after deducting 25% annual tax rate. This is the second table to the right of the simulated spreadsheet above.
The investor who put his fixed income in the tax deferred account, and the stocks in taxable accounts, ended up with $1079.88 after 30 years
The investor who put his fixed income in taxable account, and the stocks in tax deferred account, ended up with $948.88 after 30 years.
The conclusion on this exercise is that if all else is equal, you want to put the asset with the lower tax advantage in retirement accounts. This means that you do have to consider expected returns, and the tax efficiency of the asset. For example, if you have to decide between placing a common stock or a Real Estate Investment Trust in your IRA, it may make sense to put the REIT in it. This is because a large portion of the REIT returns is generated by their generous distributions. A large portion of REIT distributions are taxed as ordinary income. For REITs whose distributions have a larger return of capital component however it may make sense to hold those in taxable accounts. In my case, after disposing of most of my individual REITs, I ended up purchasing a REIT fund in my retirement accounts. This essentially eliminated tax drag on my investment results on this sector, while substantially reducing my future tax paperwork.
As a result of those calculations, I have decided that equities and REITs have a higher priority over fixed income in retirement accounts. As long as interest rates stay below 4% – 5%, this may be the best course of action for me. If you happen to hold non-dividend paying stocks such as Berkshire Hathaway (BRK.B) and Markel (MKL) as long-term holdings, it may make sense to hold those in taxable accounts.
I am also considering not owning any bonds in my retirement accounts, and owning stocks there instead. I may prioritize purchasing fixed income in my taxable accounts, as opposed to equities, as a result of this analysis. Given everyone’s expectations for rising interest rates, it may make sense to hold bonds directly to maturity, as opposed to through a fund. Plus, given today’s lower interest rates, even funds with a low expense end up taking as much as 10% of your expected return in terms of fees. By controlling the maturities, I also have a better idea on the amount and timing of cashflows.