As vital as taxes may be to a functioning nation, relatively few people are clamoring to pay more of them. (Much respect to Mr. Buffett, for example.) That's especially true when it comes to the money we're saving for our retirement, which is doubtless why previous Congresses created tax-advantaged accounts and various other vehicles and rules designed to encourage us to invest for old age.
But not all tax advantages are created equal -- each one will do you more good when applied to certain types of investments rather than others. Figuring out precisely which stocks, bonds, funds, and so on should go into what type of investment account is a question of asset location. (Not to be confused with the equally important but better-known topic of asset allocation.)
In this segment of a Motley Fool Answers episode, hosts Alison Southwick and Robert Brokamp -- with help from Megan Brinsfield, director of Foolish Planning with our sister company, Motley Fool Wealth Management -- answer a couple of listener questions on how to figure out what types of assets should go where. And, as they explain, the key things to consider in this strategic tax maneuvering are two other T's: time and turnover.
A full transcript follows the video.
This video was recorded on March 26, 2019.
Alison Southwick: The first question. Are you ready?
Robert Brokamp: We're ready!
Southwick: Try to contain yourself. It comes from Emory. "I have a 401(k), a Roth, and am just getting ready to open my first investment account outside of retirement savings." Yay! "I was thinking about making this a more dividend-focused account, but then thought that this might be more complicated as there may be tax implications with capital gains. Do you have any recommendations for tax optimization? Should I just keep a Foolish mixture in each account, or is there a benefit to focusing investment categories -- growth, value, dividend, ETF -- into specific types of accounts?"
Megan Brinsfield: In general, when you're thinking about asset location, which is what this question is about, there are two variables that tend to matter more than others. One is the length of time that you have to invest. If you're investing as a young person for multiple decades, the more it matters to get the right assets in the right buckets.
And then the other thing that is a big variable is the turnover in your account. How often are you selling stocks or collecting a dividend off of those stocks? And the more frequent that is, it erodes that tax location strategy.
If you have a long time to invest and low turnover, then having dividend payers inside a retirement account is going to be better for you. But in general, you want to have stocks that don't pay a dividend -- that are just growing because you're holding them and they're appreciating -- in a taxable account where you're not incurring any tax at all until you sell those investments ultimately.
Southwick: Let's build off that question with one from Patrick. "I listened to your recent episode featuring Larry Swedroe and immediately bought and read his book." Wow! Way to sell, Bro!
Brokamp: Good job! And Larry!
Southwick: The book is called Your Complete Guide to a Successful and Secure Retirement. "Among other things, he asserts it is generally better to hold fixed-income investments in tax-advantaged accounts [and] IRAs, 401(k)s, and equities in taxable brokerage accounts. What are your thoughts on this? My employer offers 12 or so funds in our 401(k) plan, but only one is a bond fund. What's a boy to do?"
Brokamp: Yes, this is another asset location question, and as Megan suggested, the longer you have, the more this matters. Back when I first started writing about this, -- and it was more than 10 years ago -- people would often cite the study -- I think it was from USAA -- that found that good asset location could increase your after-tax wealth by 15%. So it definitely matters, but the longer you have to invest, the more important it is.
What Larry was citing in his book is some general advice that many studies have found, which is if you have fixed income -- a bond, for example -- they're very tax inefficient because they pay income every year and it's taxed at an ordinary income tax rate, so it would make sense to have those in tax-advantaged accounts.
Compare that to, let's say, a stock that doesn't pay a dividend, like Berkshire Hathaway, which I own. If you bought that and you held it for 30 years, you'd never pay taxes on it until you sell, so it has its built-in tax advantages. That's the basic idea behind this general advice.
That said, some bonds are more tax efficient than others. For example, a municipal bond is tax-free if you live in the state or locale that it operates. You should have that outside of your tax-advantaged accounts. And then some stock strategies are very tax-inefficient if you're a frequent trader. If you own an actively managed stock fund that has high turnover and lots of dividends, those would be better inside the retirement account.
So it gets a little complicated. I think the best thing for you to do is just Google "asset location" and you'll find some good articles that rank investments according to tax inefficiency. It's basically you start at the top, put those things in your tax-advantaged accounts until you fill them up, and then whatever you have left over, you keep outside of those.