When saving for retirement, many people use a combination of tax-deferred and taxable investment accounts.
But how should you allocate your portfolio between them? Is it better to put high growth assets in the tax-deferred accounts or is it better to put tax inefficient assets in them? The answer may be both, but there are definite strategies to consider when choosing where to hold your savings.
Given the tax-favored treatment of retirement accounts, it’s worth asking why you’d use a non-retirement account at all. One possible could be that you've maximized the annual deferral amount allowed to your retirement plan, but still needs to save more for retirement. This often happens for individuals whose income is above the compensation limit, or those who start saving for retirement later in life.
Another reason someone might choose to use both types of accounts is as insurance against the possibility that they will be paying higher taxes in retirement, since it’s tough to predict where tax rates will be years or decades in the future. Overall, tax levels are generally expected to rise, yet many people will be in a lower bracket upon retirement as their income falls when they stop working. A combined strategy involving both pre-tax and post-tax accounts can provide a hedge against this uncertainty.
So how should you split up your investments? Let’s look at stocks first. Here, some investments benefit more from being in a tax-preferred retirement account than others. Obviously, investments that are highly taxed should be there. For example, if you have to choose, it would be better to put equity investments designed to produce income from dividends in a retirement account while putting growth-oriented assets in a non-retirement account because even though most dividends are qualified and receive favorable tax treatment, the fact that taxes must be paid on them will diminish their growth potential. Similarly, accounts with high turnover should be in retirement accounts while buy-and-hold strategies can be placed in non-retirement accounts. Again, greater turnover generally creates a higher tax bill, and strategies subject to more tax should go into the retirement accounts.
It’s a similar story for bonds. Taxable fixed income assets often belong in retirement accounts because interest income is subject to ordinary income tax rates rather than the lower capital gains tax paid on dividends. More specifically, when analyzing your bond holdings, those with the higher returns should go into the retirement account while those with lower returns can be placed in non-retirement accounts. Obviously, municipal bonds or other tax-free investments should never be put into a retirement account because they are not subject to federal income tax and sometimes are exempt from state taxes as well.
But what about allocating stocks and bonds between accounts? Would it be better to put all equities in the retirement accounts and all fixed income strategies in non-retirement or vice versa? That depends on the particular portfolio, but if the returns are similar for both its stock and bond portions, then a mixed strategy could be fine with both equities and fixed income spread across retirement and non-retirement accounts. But tax efficiency does matter. A portfolio with tax inefficient strategy paired with assets expected to produce lower returns can have as much as a three percent lower total rate of return than a more tax-efficient growth strategy.
But as a rough rule of thumb: Retirement accounts should hold equity assets that pay dividends and have high turnover, as well as fixed income with higher returns. Non-retirement accounts would hold growth equities with low turnover, fixed income with lower returns, and any municipal bonds.
Please keep in mind that this only considers one part of portfolio allocation. Any decision will also have to take into consideration other variables such as risk or liquidity. As always, these decisions should be made in the context of a comprehensive financial plan.
Ann G. Schnorrenberg, Ph.D., is a Financial Planning Associate at Monument Wealth Management, a Registered Investment Advisory firm located just outside Washington, D.C. in Alexandria, VA. Follow Ann and the rest of Monument Wealth Management on Twitter, LinkedIn, YouTube, Facebook, and their “Off the Wall” blog which can be found on their website.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.