To build assets for the future, investors seek to create diversified portfolios with a mix of investments that match their time horizon and their appetite for risk. In practice, that means portfolios are generally composed of different types of equity (stocks) and fixed-income (cash and bonds) investments.
But beyond the mix of investments you hold, where you hold various assets can have a significant impact on your tax liability and ultimately on your returns over the long run.
Investors often have accounts that fall into three different categories of tax treatment:
- Tax-free accounts (Roth IRA or Roth 401(k))
- Taxable accounts (brokerage account)
- Tax-deferred accounts (401(k), traditional IRA, or 403(b))
For instance, let’s say that we have an investor with one of each type of account, a tax-free Roth IRA, a taxable brokerage account and a tax-deferred traditional IRA. Now let’s assume that for this investor, the proper asset allocation of the entire portfolio (for all three accounts) is 50% equities and 50% fixed-income and that the portfolio is designed for retirement (meaning no cash reserves or short-term goals need to be funded from this portfolio).
Some investors would assume they need the same 50% equities and 50% fixed-income mix in each of the three types of accounts. But many advisors would agree that some asset types are more suitable in certain accounts.
What assets are best suited to each type of account?
Generally speaking, you want those asset classes with the most possible growth to be in tax-free Roth accounts because you won’t be taxed on the withdrawals.
Having equities with slightly less growth in taxable accounts is wise because the capital gains and qualified dividends will be taxed at a lower tax rate than your ordinary income rate. You also have the opportunity for tax-loss harvesting to offset gains from other investments. Another positive feature of having the equities in a taxable account is that the way they are valued at the time of the owner’s death can result in a huge tax savings for her spouse or heirs.
Having fixed-income investments in tax-deferred accounts makes sense because you do not want extra income while you are working — your income tax rate is presumably higher than it will be later on. Generally, your income tax rate is lower during retirement, when you would be withdrawing money from a tax-deferred account.
To determine where different assets should be held, let’s look at the characteristics of six asset classes:
- Large-capitalization U.S. equities: High growth with some dividends
- Small-capitalization U.S. equities: Higher average growth, but fewer dividends than large-cap equities
- Foreign equities: Mostly growth with some dividends
- Emerging markets: Most volatile of the assets classes, with big swings from year to year
- Real Estate Investment Trusts: One of the best performers over time, has a high annual dividend payout
- U.S. and foreign bonds: Reduce volatility associated with equities and provide dividends
Based on these characteristics and the tax logic described above, this chart illustrates which investments are best suited for each account type on a scale of 1 to 3 (1 is the most appropriate):
|Large-cap U.S. equities||Small-cap U.S. equities||Foreign equities||Emerging markets||REITs||U.S. and foreign bonds|
(Roth IRA or Roth 401(k))
(401(k), traditional IRA, or 403(b))
To maximize your retirement income, you need to grow your nest egg in a tax-efficient fashion. The following example illustrates how big a difference it can make in the long run.
Let’s say that U.S. small caps have an average return of 9% a year, foreign equities have an average return of 6.5% and the aggregate bond average returns 4.5% annually.
If you started an account for each investment type with $5,000 in the first year and added $5,000 to each account each year, at the end of 30 years, you would have the following:
- Small-cap U.S. equities = $747,876
- Foreign equities = $464,946
- Aggregate bond average = $323,762
While these numbers are hypothetical, it’s easy to see the value in holding higher-growth assets in tax-friendly accounts. If the returns on those assets were taxed, your tax bill would be a lot higher.
Consult a planner
The difference in how your investments are taxed can have a large effect on how you meet your long-term goals. But if this seems too complex or you are uncertain about how to invest while minimizing your taxes, consider working with a professional. To be sure you get the best outcome for your retirement, consult a certified financial planner who does not sell any products. To find such an advisor near you, contact the Garrett Planning Network or the National Association of Personal Financial Advisors.
Michael Chamberlain, CFP, AIF, is a fee-only advisor and owner of Chamberlain Financial Planning and Wealth Management with offices in Sacramento, Campbell, and Santa Cruz, California. http://chamberlainfp.com/