Tax-favored accounts like Roth IRAs, qualified retirement plans, and 529 plans present some useful options to investors. The first part of this article discussed using tax-free vehicles like Roth IRAs and 529 plans for your most aggressive investments, while keeping municipal bonds in standard taxable accounts. Yet for most investors, medium-risk investments like domestic large-cap stocks and taxable fixed-income securities make up the bulk of their asset allocation. Deciding where to put these core assets is not always as simple as it seems.
The standard wisdom
Historically, many financial planners tended to treat retirement investing separately from other investment accounts. Focusing on the fact that saving for retirement is a lifelong pursuit, the long investment horizon generally supported the use of more aggressive investments within an IRA or employer plan. The tax-deferred nature of these retirement accounts allowed easy, painless rebalancing and reallocation of investments without concern for tax liability on capital gains. Furthermore, because many investors could expect to be in lower income tax brackets after retirement than during their careers, maximizing the use of IRAs and qualified plans could lead to huge tax savings.
Arbitrarily separating retirement from other aspects of personal financial planning was helpful for some clients who needed things to be as simple as possible. As financial planning became more sophisticated, however, some planners found that they needed to take the entire investment portfolio into account in order to reach the best outcome for their clients.
The current tax situation
The conventional wisdom of having a high allocation of stocks within IRAs and retirement plans while keeping fixed-income securities in taxable accounts worked well after the tax reforms implemented by President Reagan in 1986, which leveled tax rates on wages, investment income, and capital gains. However, as preferential treatment for capital gains crept back into the tax code in the 1990s, a corresponding penalty for holding stocks in tax-deferred accounts emerged. When President Bush added not only further reductions in capital gains rates but also a preferential rate for stock dividends, this penalty became hugely significant.
Under current law, taxpayers in the highest bracket have a tax rate of 35% on ordinary income, but only 15% on stock dividends and long-term capital gains. However, all distributions from retirement accounts are treated as ordinary income, even if some of the income within the account came from stock dividends and long-term capital gains. As a result, the higher taxes paid on retirement account distributions offset the value of tax deferral over the lifetime of the retirement account. Meanwhile, because interest from taxable bonds held in taxable accounts incurs the higher ordinary income tax rate, sheltering it within a tax-deferred retirement account has definite value. On the other hand, taxable bonds have less potential for appreciation than stocks, so using them in a retirement account runs counter to the traditional view of using retirement accounts for capital appreciation.
No simple answer
How these factors interact depends on the particular investment strategy each investor follows. For instance, investors who buy individual stocks that pay no dividend -- and who hold them without selling until retirement -- would do much better under current tax law if they held these stocks in a regular taxable account. Then they would pay no tax until they sold the stocks and would be eligible for the 15% long-term capital gains rate. On the other hand, for active traders who rarely hold particular stocks long enough to qualify for long-term capital gains treatment, the value of tax deferral would likely justify using a retirement account for those stocks.
For the vast majority of investors whose predilections fall somewhere in between these two extremes, it's difficult to come up with an easy solution. Mutual funds have varying amounts of portfolio turnover, and thus they distribute capital gains to shareholders on a somewhat unpredictable basis. Most investors have at least some dividend income, and analyzing the tradeoff between paying tax now at a lower rate versus paying tax later at a higher rate depends on individual factors, such as the time remaining to retirement and timing of distributions from the retirement account. Furthermore, as everyone knows by now, the tax laws that apply to your current situation could well be completely different long before it's time for you to retire. However, looking at historical tax rates suggests that incentives like preferential capital gains tax rates are likely to persist to a greater or lesser degree.
It makes a difference
In any event, keeping these tax issues in mind as you allocate investments across your tax-managed accounts can lead to a substantial improvement in your after-tax results. Consider a theoretical investor with a 25-year time horizon who has a 50/50 stock/bond allocation, with a Roth IRA, a traditional retirement plan, and a taxable account holding equal amounts of assets. Assuming 10% returns on stocks and 6% returns on bonds, calculations show that you can finish with up to 15% to 20% more in your account just by making sure you take full advantage of your tax-favored accounts.
One trait of investing that is interesting yet sometimes frustrating is that you never arrive at a solution that will work forever under all circumstances. Changing laws, economic climate, and investment options force investors to search constantly for the best mix of assets and accounts to implement their financial plans. By keeping abreast of new opportunities for tax-favored savings, investors can be confident that they're doing everything they can to maximize the value of their investments.
Be sure to read the first part of this article for more tips and tricks.