What Accounts Should I Put My Various Types of Investments In?
Today's post is for those with both some sort of tax-advantaged investment account (Roth IRA, IRA, 401(K), etc.) AND a taxable investment account (brokerage investment account like you would open at a Schwab or Vanguard). This post is also more tailored to readers with a moderate/intermediate level of understanding of investments and taxes.
Hopefully if you are at this point, you've gone through some sort of asset allocation exercise. Asset allocation is the determination of what percent of your portfolio should be in stocks vs bonds vs cash vs other types of assets (and an even deeper dive into each one). But today's post isn't about Asset Allocation, it's about Asset Placement.
Meaning, you've already figured out what percent of your portfolio should be in stocks vs bonds vs cash, etc. But which accounts do you hold each of the asset types in? Should you hold the stocks in your IRA and the bonds in your taxable investment account? Or the other way around?
You see, pre-tax and pre-fee investment returns do not matter one iota. All that matters is what your after-tax, after-fee return is -- because that's the portion that increases your retirement or investment accounts! If you generated a 1,000% return, but the fees were 950% and taxes were 50%, you made absolutely nothing. While a hypothetical and extreme example, this reality is highly at work in your investments today.
The goal of Asset Placement is to maximize the portion of investment returns you actually get to keep (after-tax investment returns).
Traditional research on this topic of Asset Placement generally says to put your bonds in a tax-advantaged account (IRA, 401(k), etc.) and to put your stocks in taxable accounts. Why? Because the tax-savings from bonds would be greater than the tax-savings from stocks.
Let's examine a bit deeper: Bonds pay you a set dollar amount of interest every year. However, the bond interest is taxable at whatever your marginal income tax rate is (meaning if you are in the 22% tax bracket, you would pay 22% tax on whatever bond interest you get each year). Whereas with stocks, you get preferential tax treatment by only having to pay what's called the capital gain tax rate (which for most people is 15%). And you have to pay this capital gain tax rate on both dividends** and any amount of gain you generate on the stock when you sell it (i.e. if you sold a stock for $1,500 and bought it for $500, you would have to pay tax on the $1,000 gain).
**For U.S. stocks only that meet a couple other criteria-- these are referred to as Qualified Dividends.
In the table below, I have shown which asset type (stock or bond) generates higher tax savings at various rates of return on both bonds and stocks. For more advanced readers, the assumptions are in italics below the table.
Table Interpretation: Green highlighted cells indicate the $ amount that stocks generate in higher tax savings. Red cells indicate the $ amount that bonds generate in higher tax savings.
Help with interpreting table below: If bonds were paying 4% in interest per year and stocks were increasing at a rate of 4% per year, stocks would generate $82,764 more in savings over the 35-year period.
Assumptions used in table:
-Original Investment: $100,000, no additional contributions after initial investment
-35 Year Investment -- no price appreciation in bonds, constant dividend rate of 2% for stocks
-22% Marginal Tax Bracket for bond interest, 15% Capital Gains rate for dividends (all are Qualified), 20% capital gains rate for stock sale all occurring with 1 transaction after 35 year period
-Annual taxes for both bond interest and dividends were paid out of investment accounts themselves
As shown by the table, over a 35 year time horizon, favor actually leans towards stocks in being more tax efficient. Of course this assumes that this is for someone in the 22% tax bracket (meaning your gross income is less than $84,000 if single and $168,000 if married).
Asset Placement is a [potentially] very complicated subject -- as it involves the projection of tax rates in the future (both ordinary and capital gains rates), as well as guessing the returns for both bonds and stocks. As such, do not view the above table as gospel, since tax rates will most likely not remain at these levels going forward and we do not know what return %'s bonds and stocks will generate over the next 35 years.
Here are some practical takeaways to consider:
1) As REIT's and Non-U.S. stocks generally do not receive the preferential tax treatment on dividends, these are often wise investments to put in Tax-advantaged accounts (IRA, Roth IRA, etc.). Consider prioritizing putting these types of investments in tax-advantaged accounts over all others.
2) As of this writing (April 2020), the 30-year Treasury bond yield is 1.40% -- this is extremely low -- which equates to lower tax savings as you aren't making very much money in bond interest, thereby alleviating some of the "pain" of the holding bonds in taxable accounts. This is in opposition with most traditional research done on Asset Placement, as bond yields have historically sat at higher yield levels.
While Financially Forgotten does not give investment advice, if you have any educational questions about your investments or are seeking objective, individual education on investments, feel free to book a free consultation call at https://www.financiallyforgotten.com/contact.