YOU KNOW WHAT sort of portfolio you want, thanks to the chapters on portfolio building, investing and financial markets. What’s next? Once you’ve settled on your asset allocation, you need to consider your so-called asset location: Which investments should you hold in your retirement accounts and which in your taxable account? The goal is to minimize your investment tax bill by keeping investments that generate a lot of immediately taxable income in your retirement accounts, while favoring relatively tax-efficient investments in your taxable account.
For your retirement accounts, that might mean holding corporate bonds, real estate investment trusts, actively managed stock funds and individual stocks you plan to trade in and out of. These investments will tend to generate a lot of ordinary income or short-term capital gains, so they would usually be taxed at income tax rates, rather than at the lower long-term capital gains rate. By keeping these investments in a retirement account, you defer that tax bill, plus you avoid the hassle of reporting all this activity on your tax return.
What if you’re dealing with a Roth account, with its tax-free growth, rather than a traditional retirement account, where withdrawals are taxed as ordinary income? For your Roth, you might ignore the above advice about holding corporate bonds and instead favor stocks. Why? Because all gains within a Roth should be tax-free, you want to take maximum advantage of that—by gunning for the higher potential long-run returns offered by the stock market.
Meanwhile, in your taxable account, you might favor tax-efficient investments that you intend to hang onto for the long haul, such as stock index mutual funds, exchange-traded stock index funds, tax-managed stock funds and long-term individual stock holdings. These investments will tend to generate modest annual tax bills and, when there are taxes to be paid, they will typically be paid at the long-term capital gains rate.
What about index funds that invest in foreign stocks? If you hold these in a taxable account, some of the dividends received by the fund may not be qualified, and hence you’ll have to pay taxes at the income-tax rate. On the other hand, by holding international stock index funds in your taxable account, you benefit from the fund’s credit for foreign taxes paid—a benefit that’s lost if you hold the fund in a retirement account.
For your taxable account, you might also favor tax-free municipal bonds, especially if you are a conservative investor and you’re in a high tax bracket. Even Treasury bonds have lately looked like a reasonable holding for a taxable account. As of 2021, with Treasury yields at 2% or less, the bonds wouldn’t trigger a big federal income tax bill if they were held in a taxable account, plus the interest would be exempt from taxes at the state level.
Our Humble Opinion: Don’t let your mix of retirement and taxable money drive your asset allocation. Yes, it makes sense to hold tax-inefficient investments in your retirement accounts and tax-efficient investments in your taxable account. But if, say, you are young and inclined to put much of your money in stock index funds, you’ll likely end up holding these tax-efficient funds in your retirement accounts—and there’s nothing wrong with that.
Next: Step 3: Low-Tax Years
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