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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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ETFs are more tax efficient than mutual funds
I have both and have made a greater allocation to ETFs in my taxable accounts in recent years for the reason you stated.
This is really interesting, but as I was reading it, I kept thinking, wow, that’s complicated. Do you have any concerns about managing all of this as you get older? I do certain things financially now that in the back of my mind I’m imagining I’ll need to simplify as I approach/pass 70 or so (I’m 63 now).
I’m not sure it is any more complicated than managing any asset allocation: Yes it was a bit complicated to make the changes to get to the new allocations. But, once established, it is maintained by periodic rebalancing to the desired percentages, just as I was doing before. However, I am cognizant of the fact that my whole portfolio is fairly complicated and I am considering how I will simplify it and get help when I am older.
Another consideration is foreign stock. If you want the deduction for foreign tax you need to hold this in taxable.
This is true. As it stands, I have foreign holdings in all account types. Last year, my foreign taxes paid in my taxable account exceeded what I could take as a credit in the current year. I understand that I can carry that forward, but I may never get the full credit for all that I have paid.
Interesting article on a topic we pay attention to as well, similarly in many ways. A few differences may be of interest:
Like you, all our bonds except Series I are in Traditional tax protected accounts, but noted you have more volatile bonds in your Roth. Why have any bonds in your Roth? Our Roths are all in stock funds, mostly mid/small cap or international. If we think we might start drawing from them, we’d choose less volatile investments, possibly including bonds. But if you never plan to, there seems to be no reason to have bonds in your Roth.
Most of our cash is also in tax protected accounts. In taxable, I gather we have far less cash than you do. We normally spend from a premium money market fund and have maybe a year of necessary expenses there. We also have some with an online bank that we basically never touch, for diversification of custodian and accessibility purposes. We could keep even less for better tax efficiency, but like being able to access some actual cash without having to make any trades at all. If we needed a lot more cash, we would sell some stocks and make an offsetting move from cash to stocks in a Traditional IRA. Even if the market were down, this would not be selling low, as explained here.
https://humbledollar.com/money-guide/municipals-vs-taxable-bonds-in-a-retirement-account/
Also, noted you have REIT funds in your taxable account. Aren’t distributions from these taxed as ordinary income?
Thanks for your suggestions. To clarify, the alternative investments in my taxable account do not include REITs. I learned that lesson a number of years ago! (Although as Joe notes below, it is less of an issue since 2017.)
I had considered having 100% in stocks in the Roth accounts. The advice I got said to go with 90% so for now that is what I did. I may still go to 100% in the future. By choosing a high yield bond fund, it does move with the stock market.
Similarly, I am moving toward less cash in my taxable account, consistent with the recommendations I got. Last year, due to hitting age 65, I will need less cash available… but I have to get comfortable with that.
I have 100% stocks in my Roth IRA, not that it’s very big. Could you explain the advice to hold only 90%?
When I met with the CPA/financial advisor, they asked what overall allocation I was comfortable with. That is the starting point. I wanted 75% in stocks. I was also starting with just under 80% in stocks in our Roth IRAs. Their recommendation was to up it to 90% while reducing the stock allocation in the Traditional IRAs. I didn’t ask, but I suspect they were looking for a small amount of ballast in the Roth accounts if the stock market were to drop significantly. I’m not sure 10% would make much difference, especially since I chose a high yield bond fund. If I went to 100% in the Roth, I would need to further reduce stocks in the Traditional IRAs to average out all accounts at 75%. So, I do agree that 100% in the Roths is perfectly acceptable for long term money that you don’t expect to draw on. In my case, it would require further adjustment in my other accounts. I suspect that this marginal 10% allocation is not worth the ink we are all putting into it.
Years ago, I saw numbers that showed that a 90% stock-10% bond portfolio had the same return as a 100% stock portfolio — thanks to the performance bonus from rebalancing between stocks and bonds. The 90-10 portfolio, of course, also had the advantage of lower risk.
This refers to a whole portfolio though, not a reason to have 90-10 in a specific account. Still it suggests Howard is right that the 10% isn’t worth the ink we’re spending on it. (I know, I started it…)
Actually maybe that should have been a question. I assume it only matters in terms of whole portfolio and not a specific account.
To rebalance a 90-10 portfolio (or any portfolio, for that matter), you need a mix of stocks and bonds in some account — preferably tax-sheltered — but you’re correct that it doesn’t need to be 90-10 in every account.
Re REIT funds, I keep ours in a traditional IRA, as is often advised because REITs are required to pay out as dividends at least 90% of the taxable income they earn. However, as I learned only a few years ago, the 2017 tax cuts included a Qualified Business Income deduction that includes dividends from REITs and REIT funds. Our taxable holding of Vanguard Total Stock Market Index (VTSAX) pays out income from the REITs it holds, and its Form 1099-DIV shows the Section 199A income it paid out that qualifies for the 20% QBI deduction — a deduction available regardless of whether you itemize. To learn more, see: https://www.irs.gov/newsroom/qualified-business-income-deduction