An old question has become new again. You have tax-deferred accounts like IRAs and Roth IRAs, and you have accounts that pay taxes every year on the income they receive. Where do you put different types of assets?
The answer is that you want to put the most tax-inefficient investments inside the tax-deferred accounts. The most notoriously tax-inefficient investments, historically, have been bond funds, commodities futures funds and real estate investment trusts (REITs), which all generate ordinary income that can be taxed at 39.6% plus the 3.8% Medicare tax for higher-income taxpayers. The Roth IRA, which shelters all future returns from taxes of any sort, can be a great place for mutual funds that invest in small cap stocks, since they tend to have high turnover and historically have provided the highest gains.
In taxable accounts, you might put growth stocks which, if you hold them for more than a year, will have their price appreciation taxed at a maximum rate of 20% (or 23.8% with the Medicare surtax). Of course, you can choose to hold individual securities for much longer periods, which gives you tax deferral on its own – and, if the stocks are held until death, the heirs get a step-up in basis, which basically means any rise in value is never taxed. Municipal bonds which qualify for an exemption from federal taxes are also good candidates for the taxable portion of your investment accounts.
What makes this debate new again? Higher ordinary income tax rates, and potentially higher capital gains tax rates (up from 15% to 23.8% for tax filers who pay the new Medicare surtax) have introduced some gray areas, as have the historically low rates on bonds. When bonds were delivering upwards of 10% on the investment dollar, putting them in an IRA was a simple decision. But what if you’re cautious about rising rates and you’ve shortened maturities in a yield-starved market, so your return is closer to 1%? Suddenly, these funds are no longer a huge tax concern.
At the same time, REITs offer tax benefits like depreciation, which becomes more valuable at higher ordinary income rates. And persons in retirement may see their tax rates fall from above 39% down to 15%, which decreases the benefits of astute asset location, and might raise the value of rebalancing each year across all accounts.
Another consideration for retirees is the mandatory withdrawals required from their IRA account after they reach age 70 1/2. If the IRA is holding all the income-generating investments, then systematically liquidating those holdings means creating a higher exposure to stocks and a generally more volatile portfolio as you age – which may be the opposite of what is desired.
Saving taxes through asset location strategies is one of those rare opportunities to get additional dollars without taking additional risk; but a mindless focus on taxes without seeing the bigger picture can result in unintended consequences. The rules of thumb need to be informed by your tax bracket and other aspects of your individual circumstances – with an eye on the ever-changing tax and interest rates that Congress and the markets throw at us.
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