Maximizing Tax Efficiency, Taxable or Tax-Deferred

What is the Best Type of Account to Hold Stocks and Bonds?

            When you have money to invest, everyone wants the best returns with the smallest amount of risk.  This would be the perfect
investment if it existed, but it doesn’t.  Unfortunately no one has a perfect crystal ball to see into the future.  However, there are steps
you can take to give yourself the best chance to grow your money.  One step we will cover is asset location.

            You may have heard the term asset allocation, or “don’t put all your eggs in one basket”.  For example, you must choose
between stocks and bonds, foreign and domestic investments, large and small, and everything in between.  In general this helps to
protect your portfolio in good times and bad times.  But asset location is the process of choosing which assets to hold in which
accounts.  Most established investors have taxable and tax-deferred accounts to consider.  This creates another layer of necessary
investment planning, one that requires careful thought before you ever decide which stock and bond funds to invest in. 

There are two basic strategies.

1. Tax driven, maximize equity (stocks) in the taxable account and maximize fixed income (bonds) in the tax-deferred account.
2. Uniform approach, investing an equal amount of stocks and bonds in both accounts.

            The tax driven strategy above, contradicts conventional wisdom.  There is a misconception that stock investments should be
placed in IRA’s or other tax deferred accounts and fixed income should be placed in taxable accounts.  The logic has been, that you
will be able to grow the assets faster with tax deferral so why not use the high growth options to avoid paying tax until the last minute.
While the effect of taxes on an investment portfolio cannot be overlooked, the location has to be considered. 

 There are 5 reasons why the Tax Driven Strategy generally makes more sense: 

1. Equity investments receive more favorable tax treatment than fixed income investments.  If you have a taxable equity portfolio,
   and you hold them for over 1 year, the gains are subject to capital gains tax.  Fixed income interest is usually taxed as ordinary
   income.  Bonds pay interest each year, which if placed in an IRA is not taxed until withdrawal.

Ø      For example, suppose you are in a 25% tax bracket.  Assume you have $20,000 investment with a $10,000 cost. 
With current long term capital gains treatment you would pay 15% on the gain, or $1,500.  But if you had invested IRA
cash in equities, you pay ordinary income tax of 25% on the entire distribution, or $5,000 regardless of what your cost
was.  Upon liquidation, IRA assets will be taxed at ordinary income tax rates, whereas liquidation in the taxable
account results in more favorable capital gains rates. 

2. Equities are more volatile than fixed income assets.  Therefore, the ability to take losses in a taxable account is worth more
   than if it were in a tax deferred account.  For example if you could sell your stock at a loss, you can offset gains.  However if the
   stocks were in the IRA you lose the ability to claim that loss.  This is not tax efficient.
    

3. There is a potential for step up in basis for the heirs of the estate.  An IRA will not receive this type of treatment under current
   tax law.
    

4. Appreciated shares can be donated to charity, avoiding any tax. 
    

5. Any foreign tax credits generated by international investing are useless in an IRA.

             Every investor’s situation is different and needs careful consideration, but asset location is a key step in maximizing tax
efficiency.  Some investors may only have a tax-deferred account in which case asset location doesn’t matter.  But for the majority of
investors that have a portion of their investments in both types of accounts; where you invest your stocks and bonds today will make
a significant impact on how much you will be able to spend in the future.