PPA discusses asset allocation regularly in our monthly commentaries. This concept refers generally to the amounts invested in stocks and bonds, and how this split determines the risk-return trade-off as we help you pursue your long-term goals. Once we’ve established an asset allocation customized to your situation, a second level of analysis focuses on asset location, or where it makes the most sense to invest your assets in the different types of investment accounts.
First, a little background on the basic kinds of accounts used by investors:
- Tax-deferred, or “pre-tax”, retirement accounts, which have been given special advantages in the tax laws. Examples include Individual Retirement Accounts (IRAs) and 401K accounts at work.
- “After-tax” retirement accounts, which have different tax advantages than tax-deferred accounts. The Roth IRA is the primary example of this type of account.
- Accounts where the deposits have already been subject to income tax. These are also referred to as taxable accounts.
Because the nature of these accounts and how best to use them are primarily a function of the U.S. tax laws, we urge our readers to confirm with your accountant/attorney how the information presented below applies to your specific situation.
RETIREMENT ACCOUNTS
- Contributions to various types of IRAs (“traditional” as well as SEPs and SIMPLEs, which we’ll cover in future Comments) and work retirement plans (401Ks in the private sector in addition to 403Bs and 457s for non-profits and governments) allow for current-year income tax deductions. Earned Income that is not currently taxed allows investors to earn investment returns on that money. While taxes will be paid at some future time on the accumulated retirement account values (remember that except for Roth IRAs, these accounts are tax-deferred, not free of taxes), the tax deferral essentially functions as an interest-free loan from the government to use to grow your portfolio for retirement. The more time you have until the tax laws require you to withdraw the funds and eventually pay taxes, the more valuable this opportunity becomes.
- In addition to these tax-deductible IRAs, there is another category of tax-deferred account, known as an IRA rollover. Transfers into this type of account are not tax-deductible, but they provide the same advantage of earning untaxed investment returns over time, until the tax laws require you to take the money.
The IRA Rollover does not offer a current tax deduction because the funds have already received the benefit of the tax deduction at an earlier point in time. For example, 401k plans at work allow employees to defer taxes on the amounts they contribute into these accounts. (Employers can also make deductible contributions to employees’ accounts, also known as “matching.”) When employees leave a job or retire, they are able to transfer all of the accumulated funds into their own IRA Rollover account, and do their own tax-deferred investing there.
- Roth IRAs and Roth IRA conversion accounts have the opposite tax treatment. While tax-deferred retirement accounts feature deductible contributions and ordinary income taxes on withdrawals during retirement, Roths do not provide an up-front tax deduction (hence the term “after-tax), but all of the withdrawals from Roths during retirement are tax-free. As with tax-deferred IRAs, Roths involve special rules that can merit consultation with your accountant.
- Unlike Roths, tax-deferred retirement accounts do require taxable withdrawals at a certain point. These are known as Required Minimum Distributions (RMDs). Starting with the year in which the account owner reaches age 72 (the start date used to be age 70 1/2), the IRS uses an actuarial table that establishes the required percentage to be withdrawn, which is then applied to the account balance as of the end of the previous year. For example, if the actuarial table indicates a 6% withdrawal for someone aged 80, and the account had $1 million at the end of the previous year, then $60,000 would be the amount of the current-year RMD. The full $60,000 counts as taxable income in the year withdrawn. Taxes must be paid even if the account owner does not need to use the money. While many people question having to pay taxes on unneeded funds, it bears remembering that this money was not taxed at all previously, including a tax deduction for the contributions and tax-deferral for all investment returns in the account.
- This brings us to the issue of asset location in retirement accounts. This is not an effort to pick outperforming asset classes, but rather a question of whether the tax laws deliver certain outcomes that make it preferable to invest in one asset class or the other. For example, if a tax-deferred account is used to actively trade stocks looking for gains, there would be no taxes to pay on those gains when the stocks are sold within the account. The offset to this advantage is that all the taxes due on withdrawals are considered ordinary income, so the lower capital gains rates available on stock gains outside retirement accounts are not available.
Tax-deferred accounts also offer benefits for bond investing. Taxable bonds almost always pay higher interest than tax-exempt bonds do. Since there is no tax on the taxable bond interest when held in a tax deferred account, this argues in favor of investing the taxable bond portion of your asset allocation in the tax deferred account, assuming it fits into your overall asset allocation targets.
A final consideration arguing against holding stocks in tax-deferred accounts is that these accounts do not provide a “stepped-up” cost basis at death. This provision can significantly reduce capital gains (typically associated with stocks) and related taxes, but only if the stocks are held outside retirement accounts.
- Roth IRAs, on the other hand, can be excellent accounts to locate stocks, since the gains are not subject to any taxes, either income or capital gains, on withdrawal. Roth IRAs also do not have RMDs, since the taxes were paid at the time of contribution.
TAXABLE ACCOUNTS
These include individual and joint accounts, with many variations. Examples include transfer-on-death (TOD) and Trust accounts. The money deposited in these accounts has already been subject to income tax, so the different variations typically address gift and estate taxation, which has completely different rules than the income and capital gains tax systems.
- Investment returns have two sources: price appreciation (or depreciation in case of declining prices), and income generated by the investment. While this is true of investment returns earned in all types of accounts, the distinctions are much more important when investing in after-tax accounts. Historically, income is the main source of investment return from bonds, whereas price appreciation is the primary source of return from stocks.
- Price appreciation is the difference between what the investor paid for his/her investment, and what that investment is worth currently. A major advantage to taxable account investments with some opportunity for price appreciation is that the appreciation goes untaxed until the investment is actually sold, in which case the gain is “realized.” Sales in taxable accounts trigger capital gains (or losses), with taxes paid at favorable long-term capital gains rates if the investment has been owned for more than one year. (Realized losses can provide other tax “benefits.”) Note the difference between this tax treatment and the treatment of gains in retirement accounts, where higher ordinary income taxes are triggered by withdrawals, not sales, no matter the source of the gain. All of this argues for stocks to be held in taxable accounts, again assuming you have one or more taxable accounts and stocks fit in your overall asset allocation.
- Income consists of dividends from stocks and interest from bonds. Bond interest can be tax-free or taxable, a distinction worth considering when making bond investments in taxable or retirement accounts. Tax-exempt bonds (also known as “municipal” or “muni” bonds since they are issued by State and local governments) typically pay less interest because the income isn’t subject to Federal, and in some cases, State income tax. But you only get the tax benefit of this interest income when the bonds are held in a taxable account. So while taxable bond investing makes more sense in a retirement account, if your overall allocation and tax situation calls for tax-exempt bonds, they should be held only in taxable accounts.
There are many details we have not covered in this discussion, but we want to stress the importance of asset location in the investment advice we provide you, in conjunction with your account/attorney. Please feel free to check in at any time with questions about this complex topic.