Keeping Uncle Sam in Mind When Allocating Investments

In a prior post, (“Location, Location, Location” – May 31, 2013) I detailed just how important it is for investors to take a top-down approach across all their investment accounts in order to minimize the damage incurred to their net worth by equity and bond funds with exorbitantly high fees.  Essentially, I made the argument that investors need to be aware of what funds are available in their 401(k) vs. other investment accounts (Rollover IRA, Traditional IRA, Roth IRA, and brokerage) and allocate their investments with a sharp eye on expenses because funds available in 401(k) plans are sometimes very expensive.

As a corollary to that approach, I believe investors should also allocate assets by account type with an eye on tax liability.  (Disclaimer: I am not a CPA or enrolled agent, I am simply providing guidelines and food for thought).  By that I mean people should seek to optimize their asset allocation among taxable or tax privileged accounts.  Why?  Because the attributes of those investments “housed” in these accounts matters a lot to Uncle Sam, who we all know is quite interested in your income and most importantly, the U.S. government’s “fair share” of it.

So what’s the message?  In very broad terms, you want to keep your income-paying assets in your tax privileged accounts and your growth assets in Roth IRA or taxable accounts.  Now let’s get into the details.

Let’s start with what makes the most sense for tax deferred accounts.  These would be 401(k)’s, Traditional IRAs and other “retirement accounts” (403(b), etc).  As most people know, contributions to these accounts are tax deductible (subject to limitations) and individuals do not pay taxes on the growth or income within the account until it’s time to take RMDs (required minimum distributions) upon retirement or if cashed-out prior to retirement (with penalties).  Given the “tax deferred” nature of these accounts, I believe investors should “house” their income earning assets (like interest-paying bonds, REITs or high-dividend yield stocks) in these accounts so the income paid throughout the year remains tax sheltered and not reported on the annual 1040 as income.  Of course your RMDs are taxed when you are using them in your retirement but theoretically, you would be in a lower tax bracket at that time when compared to your peak earning (and saving) years.

The next account for your assets’ “residence” could be a Roth IRA.  While contributions to a Roth IRA are not deductible (and subject to eligibility based on income), I think they are best suited to hold small cap and emerging market equity funds which are typically higher growth, higher volatility, lower income paying and are usually characterized by funds that are “inefficient” for tax purposes.  These more nuanced funds are usually comprised of lesser-known stocks or bonds that are traded more often by the fund manager during the year.  Thus these funds could recognize capital gains (due to trades during the year), but with the Roth IRA you do not pay tax on the withdrawals (after age 59 ½) due to the fact you already contributed “after-tax” money.  In addition, these are higher-growth / higher-volatility funds best suited for long-term holding as again, due to the special advantage afforded the Roth accounts, individuals would not pay taxes on the increase in the account value due to growth.

Finally, we have the standard “taxable” investment account which would be a brokerage account that could hold your “non-retirement” investments.  In these accounts, we would seek to avoid housing assets that pay relatively higher dividend and interest income which is (as the name would indicate) taxable as investment income.  In addition, you would pay capital gains tax (typically at a lower rate than ordinary income) on the gains of appreciated assets that were sold, assuming the assets were held for over a year.  If held for less than a year, the gain on the sale would be reported as ordinary income and pay the higher rate- not a good idea. In this account, I would look to allocate your liquidity position (cash) and your large cap equity funds, preferably index funds with low turnover.  Your cash position would throw off minimal income, and your equity index funds would not pay the highest dividends. In addition, these funds aren’t usually aren’t traded around as much during the year due to minimal “membership” changes in major indexes.  If you did need to take funds from this account, you should of course seek to offset gains with losses on any asset sales and try to keep you taxable proceeds as capital gains, not ordinary income.

Obviously, taxes are not the most stimulating or exciting topic to discuss but given the fact that taxes likely comprise families’ largest annual liability (in terms of dollars), I believe investors should keep a sharp eye on any means to legally minimize their tax burden.  It’s not easy to keep track of all the assets across a multitude of account types nor is it fun to keep up on changes in tax law.  But with a holistic and “top-down” approach, I believe a smart and “tax efficient” allocation provides a substantial bang-for-your-buck.  Most importantly, an optimized allocation keeps a bigger portion of your hard-earned dollars where they belong- in your hands, not the government’s.

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