| Save Money by Carefully Managing Your Taxable and Tax-Qualified Accounts |
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Fundamental Portfolio Management Series Save Money by Carefully Deciding How Your Investments
Should be We believe that investors who pay attention to this area of portfolio management will save themselves money. How much depends upon a number of factors, but for some investors it could be 0.30 - 0.50% of your portfolio's value every year. If you have a portfolio of $100,000, that comes to $300 to $500 in the first year. This may not sound like much money, but if you save it every year and your overall portfolio grows, the savings could be substantial. While we cannot predict the future, we believe that committing an hour or so of your time to understand these concepts is definitely worthwhile. First, you can determine if there are good opportunities to start saving money now. Secondly and just as importantly, you can start to incorporate these best practices into all your buying and selling decisions. If you do that, hopefully you will reap the potential long-term benefits of this strategy with relatively little effort each year. The strategy hinges on the fact that most investors hold investments in two types of accounts: one that is taxed “normally” and another which has special tax advantages such as 401(k) or IRA. In order to distinguish them we will refer to the “normally” taxed accounts at “taxable” and the accounts with special tax advantages as “tax-qualified.” Over the past few years, many tax-qualified plans like 401(k)s and IRAs have been giving account holders more control over how their money is invested. Farm Creek recommends you use this flexibility to maximize your after-tax returns by carefully separating your investments into your taxable and tax-qualified accounts. This may sound complicated and difficult, but it is really not that hard. This short report, a little patience and some basic math are all you need. Here is the plan:
We want to remind readers that when evaluating investment strategies, they should carefully consider all their unique circumstances before making decisions. These include but are not limited to:
Please d o not work to capture 0.30 - 0.50% with this strategy and inadvertently throw away 1.00 – 2.00% or more in the process. For individual tax advice, please contact a tax professional. I. Strategy Overview The key to the strategy is that the government allows us, in fact encourages us, to have both taxable and tax-qualified accounts, which are not surprisingly taxed at different rates at different times. But, the after-tax return for many investments can be greatly affected by the type of account in which they are held. In most cases, investors need to determine which of their investments would be best held in their tax-qualified accounts. The basic rule of thumb is to hold your investments with highest “potential” taxes in your tax-qualified account. Here is a simple example (although it may not seem simple until you finish this report). Suppose you have two investments: $50,000 in a stock index fund and $50,000 in a bond index fund. If your IRA (a tax-qualified account) has room for $50,000 of investments, which investment should you hold in the tax-qualified account? All else being equal, the rule of thumb is that you should hold investments with the highest “potential” tax in the IRA. So we need to look at the income from these two investments and how they are taxed. If the bond fund has interest income of 4% a year; and this income is taxed at 25%, the “potential” tax is 1.00% of your investment (0.04 * 0.25 = 0.01 or 1%). If the stock fund generates dividend income of 2%, which is taxed at 15%, you potentially lose 0.30% to taxes (0.02 * 0.15 = 0.003 or 0.3%). Therefore, in order to earn the highest after-tax returns it is best to hold the bond fund in the IRA and the stock fund in your taxable account. II. Some Basics of Tax-Qualified Accounts The basics of how tax-qualified accounts work are relatively simple. Tax-qualified plans such as a 401(k), 403(b) or Traditional IRA are generally funded with pre-tax income and the assets are allowed to grow untaxed. When funds are removed from the plan they are taxed at the investor's ordinary tax rate at that time. Except under special circumstances funds cannot be removed before age 59½ without a penalty and after age 70½ you are required to make annual withdraws. Tax-qualified plans are very attractive since they allow investors to invest pre-tax dollars. The most important reason investors would not want to do this would be if they thought their tax rates would be higher when the money is withdrawn. There are also other positive aspects to these plans which include:
One thing to note in this discussion is that there are differences between Roth IRAs and Traditional IRAs. Roth IRAs are funded with after-tax dollars unlike Traditional IRAs which are mostly funded with pre-tax dollars. For some investors Roth IRAs are very attractive as all income earned on assets goes untaxed if withdrawn properly. We caution readers that the main focus of this report covers Traditional IRAs, not Roth IRAs. With Roth IRAs, we would alter the analysis to more thoroughly take into account capital gains which occur on an ad hoc basis, but we do not think the changes would be significant. Let us move on to taxable accounts, which do not have any special tax or savings benefits. These accounts, like an IRA will probably be located at a brokerage firm, a mutual fund company or a bank. Collectively we will refer to your investments in these accounts as “taxable.” How they are taxed can be very complicated and that is why tax professionals are very important. But for this note we want to lay out a few important highlights.
III. Listing Your Major Investments The easiest way to tackle this is to list your investments and associated tax considerations as shown below and in Table 3. (We recommend using a spreadsheet, but you do not need to.) When listing your major investments, do not go crazy itemizing everything; grouping similar stocks, bonds or funds together is fine, especially at this point. When making decisions, if you find some of the investments fall on the cusp, you can always go back and drill down further. While it does not really matter in what order you list your investments, here is a simple example that makes sense.
IV. Calculating Each Investment's Potential Tax Now that you have your list of investments, continue with these steps to calculate the “potential” tax.
Marginal Tax Rates for 2004
Potential Federal Tax if Assets Are Held In Taxable
Account V. Shift investments between accounts in order to minimize tax payments. Now take the information from Table 3 and re-sort the order of your investments based upon their rankings in column F. The result should resemble the format illustrated in Table 4. This is your road map for making decisions. To the extent reasonable, you will want to fill your tax-qualified accounts with the investments at the top of your list and work your way down. In our example the asset with the greatest “potential” tax is the Aggressive Growth Fund. It has a “potential” tax of 2.5% due to short-term capital gains of 10% and a tax rate of 25% (0.10 * 0.25 = 0.025). The second most highly taxed investment is the REIT fund where dividends are treated as ordinary income and do not qualify for preferential tax treatment. Near the bottom of Table 4 are stock index funds which distribute a small amount of dividends and little or no capital gains. And of course tax-free municipal bonds, upon which you pay no federal income tax, are at the bottom.
Assets Ranked by Potential Tax Liability Before you start rebalancing your portfolio, remember these points:
One issue which at first confuses many investors is holding investments likely to be sold in an emergency, in a tax-qualified account where they can not be touched. Here is our recommended solution - in an emergency, if you need $5,000 from the short term bond fund in your IRA; you should sell $5,000 of an asset in your taxable account (i.e. stock index fund) to get the cash you need. Then in the IRA, move $5,000 from the short term bond fund to a stock fund. After the transactions your short-term investments will be reduced while your other investments will remain unchanged. Obviously you don't want to do this very often if your transaction costs are high as this took three transactions rather than one to complete the transfer. Also, there could be a tax liability on the sale of the fund in the taxable account. We have seen some professionals suggest that a portion of each investment belongs in your tax-qualified account. But having all your investments represented in your tax-qualified account, you will most likely be able to rebalance your portfolio each year while only making trades in the tax-qualified account and this should help avoid potential capital gains taxes. All of this is true, but we are not convinced that the potential savings are worth the added paperwork and complexity especially taking into account that putting stocks in tax-qualified plans and potentially forcing bonds into the taxable accounts has an immediate cost. VI. Potential Savings As mentioned in the beginning, the affect of “correctly” and “incorrectly” separating your investments can potentially result in a return difference of 0.30 – 0.50% of assets a year. In this section we will use an example to illustrate this difference in hypothetical returns. We will start with the same assumptions we used in section I.
It turns out that under the current tax code it is always more advantageous to hold the bond fund in the tax-qualified plan and the stock fund in the taxable account. If done the other way around, returns would be 0.30 – 0.50% lower every year. Table 5 shows the hypothetical after-tax returns of holding the investments in either configuration. Investments in both accounts grow at the same rate but are taxed differently. In the taxable account interest income and/or dividends are taxed at the appropriate rate and reinvested each year while capital gains are only taxed at the end of the period. In the IRA the only tax liability occurs when the assets are withdrawn after ten years. It is interesting to note that while it would generally be assumed that the tax-qualified plan would be the optimum account for either asset, it is not true. The tax code's preferential treatment of long-term capital gains and qualified dividends overwhelms the power of dividend income growing tax-free and the stock fund performs better outside a tax-qualified plan at all tax rates. On the other hand, it is almost always more advantageous to hold your interest-bearing investments in a tax-qualified account since interest is taxed at ordinary rates.
Account Holding Effect on After-Tax Returns Now is the time to take action. If you have gotten this far, collecting the information and doing the work will not be that hard. Do it! | Back to the top | Back to the previous page | This site uses frames to navigate. If you do not see the navigation menu on the left part of your screen, please click here to refresh this site. © 2005 Farm Creek. All rights reserved. Unauthorized access is prohibited. |
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