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Location, Location

Howard Rohleder

WANT TO IMPROVE YOUR portfolio’s long-run performance? You could boost your stock allocation—something I wrote about last year—or cut your investment costs. But don’t overlook another key strategy: thinking carefully about which accounts you use to hold your various investments, or what financial experts call “asset location.”

My wife and I have taxable accounts, Roth IRAs, traditional IRAs and a health savings account. Earnings in each account get different tax treatment both now and in the future. By carefully allocating our investments among these various accounts, we can reduce the taxes we pay over the long term.

Time horizon is a key consideration. We’re unlikely to ever spend down all our assets. As a result, some accounts have an unknown but likely very long time horizon. At the same time, we need to generate some income to cover living expenses, so other accounts have a much shorter time horizon. Because we have some guaranteed cash flow coming in from a pension and annuities, and will eventually have more from Social Security, we’ve settled on an overall stock and alternatives allocation of 75%.

How should we allocate our investments among our various accounts? We sought some professional advice and, based on that, here’s how we’re thinking about each account type:

Taxable accounts. Our top priority is to maintain sufficient cash for living expenses and financial emergencies. That money is invested conservatively and generates interest income that’s taxed as ordinary income. The key is to have enough cash, but not too much, to meet current spending needs.

The remainder of our taxable money is invested in individual stocks and stock funds. That helps to minimize our tax bill, because the dividends and capital gains are taxed at preferred rates. Over time, we’ve added more index funds, which are less likely than actively managed funds to make capital gains distributions. I’m working toward having 80% of our taxable money in stocks and alternatives. This latter category consists primarily of some real estate investment trust funds, though I also own a PIMCO diversified commodity fund in my Roth IRA.

Traditional IRAs. In seven years, we’ll have to start taking required minimum distributions (RMDs) from our traditional IRAs. Because these accounts were funded entirely with tax-deductible dollars, all withdrawals are taxed as ordinary income. We can’t control the size of our RMDs—that’s dictated by the tax law. Moreover, high investment returns in these accounts will lead to larger RMDs, which means more taxes paid at ordinary income rates. Result: Our traditional IRAs are where we have most of our bond fund holdings, since the interest they throw off would be taxed as ordinary income anyway, plus these accounts aren’t the best place to earn high returns.

Roth IRAs. We didn’t get a tax deduction when we funded these accounts, but they come with a big benefit: Withdrawals are tax-free. We don’t believe we’ll ever have to touch this money and instead these accounts will go to our heirs. Given the long time horizon, our Roth IRAs are 90% in stocks and alternatives, and include our most aggressive fund holdings. Indeed, because of the long time horizon, even the bond fund I use is higher risk: Fidelity Capital & Income Fund (symbol: FAGIX), a Morningstar 5-star fund which focuses on U.S. high-yield bonds.

Inherited Roth IRA. I inherited this Roth IRA before the recent tax law change, so I’m able to stretch the RMDs over my lifespan, which the IRS determines to be just over 20 years. Since the RMDs aren’t taxed, maximizing earnings is the goal. I have targeted the stock and alternatives holdings at 70%. But because I need to make withdrawals every year, I buy less aggressive and more value-oriented holdings than I do in our regular Roth accounts. I also don’t reinvest the fund distributions, so cash accumulates throughout the year ahead of my annual RMD withdrawal.

Health savings account. For 10 years, we fully funded a health savings account (HSA). We were eligible to do so because we were covered by a high-deductible health plan. Rather than spending the money on current medical costs, we saved and invested it for the future.

The HSA is a small portion of our portfolio. Still, it’s a potential tax bomb for our heirs if we die without withdrawing the money. Why? While withdrawals are tax-free for us if used for qualified medical expenses, those withdrawals would be fully taxable to our heirs. We’re assuming we’ll withdraw all the money 10 to 15 years from now. With that time horizon, we’re 75% invested in stocks and alternatives. We’ll reduce that allocation as we approach the time when we’ll empty the account.

The tax law allows you to accumulate medical receipts from the time you first opened an HSA, and then use those receipts to ensure future withdrawals from the account qualify for tax-free treatment. I have manila envelopes for each year stuffed with receipts. Thanks to more than 10 years of receipts, we can withdraw any or all of the balance as a tax-free lump sum at our discretion. This makes the account a last-ditch source of emergency cash.

Before I sought advice on asset location, our traditional IRAs were much more aggressive than they are now, while our Roth IRAs were less aggressive. I hadn’t been thinking of the HSA and the inherited Roth IRA as long time horizon accounts, so they were invested more for income and less for growth.

By evaluating expense ratios and other investment costs, you can estimate how much you’ll improve your net investment performance by shifting to less expensive alternatives. Improving tax efficiency by juggling different account types is less easily quantified. But the savings are just as real.

Howard Rohleder, a former chief executive of a community hospital, retired early after more than 30 years in hospital administration. In retirement, he enjoys serving on several nonprofit boards, exploring walking paths with his wife Susan, and visiting their six grandchildren. A little-known fact: In May 1994, Howard was featured—along with five others—on the cover of Kiplinger’s Personal Finance for an article titled “Secrets of My Investment Success.” Check out his previous articles.

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