While many investors are focused on asset allocation – finding the right mix of asset classes for their level of risk tolerance, goals and investment time frame – smart investors are also closely watching their asset location. We at Capital Advantage take a tax-aware approach to stock and bond ownership.
As a rule of thumb, it’s most advantageous to concentrate stocks in taxable accounts and bonds in retirement accounts. Numerous studies support this rule, and we’ll explain why after first delving into an example.
Suppose an investor has $700,000 in retirement accounts (e.g., Roth IRA or 401(k)) and $300,000 in taxable accounts. She wants a 50% stock/50% fixed-income (i.e., bonds and cash) asset allocation. She plans to follow the guidance and focus her taxable accounts on stocks and devote her retirement accounts to bonds. Thus, her portfolio might put the $300,000 in taxable accounts fully into stocks, while the retirement accounts are divided between $200,000 in stocks and $500,000 in bonds. Or, if she wants to hold $40,000 in cash as liquidity reserves, then these funds must be held in a taxable account to serve their purpose. But the remaining $260,000 in her taxable accounts plus $240,000 in her retirement accounts should be allocated to stocks, while the final $460,000 on the retirement side is bonds.
There are two principal arguments for this asset location strategy. First, long-term capital gains and qualified dividends on assets held in taxable accounts receive preferential tax rates (i.e., 0% or 15% for most investors). In contrast, interest income on bonds when held in taxable accounts is taxed at higher than ordinary income-tax rates.
Second, the government bears some risk on assets held in taxable accounts. Suppose stocks earn pretax returns of -7%, 8%, and 23% in a three-year period. The investor’s average pretax return is 8%, with a standard deviation of 15%. If the investor realizes these gains each year (technically, in a year and one day) and the losses are used to offset long-term gains, then the after-tax returns are -5.95%, 6.8%, and 19.55%. The investor’s average after-tax return is 6.8%, with a standard deviation of 12.75%. Notice that the government bears 15% of stocks’ risk when held in a taxable account. Since stocks are riskier than bonds, it is more desirable to let the government shoulder part of the downside.
Furthermore, the taxpayer can control when gains and losses are realized. In general, the realization of capital gains can be timed for low-tax-rate years and capital losses for high-tax-rate years. Suppose our investor buys five stock funds in her taxable account at the end of one year. Near the end of the next year, four of the assets have risen in value, while the fifth has lost value. She could sell the losing asset and, if she has no other gains or losses, she could write off up to $3,000 of this loss against her income that year, with any remaining losses carried forward to future years.
Finally, suppose a taxable account is jointly owned by a husband and wife. The husband dies. The cost bases of the assets are stepped up to their market values at his date of death. She does not owe taxes on prior unrealized capital gain. Years later, she dies and her children inherit the assets. The children’s cost bases for these assets are stepped up to their market values at her date of death. As before, no one would pay taxes on prior unrealized capital gain.
So, pay attention to where you locate assets, while attaining your target asset allocation.
Source: William Reichenstein, Oct 21, 2018