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YOU’VE HEARD OF asset allocation. But how good are you at asset location?
On that one, I’d have to give myself a failing grade, but I hope to pass the test someday. I’ve realized I could save myself hundreds of dollars a year in taxes by relocating much of my safe money to tax-advantaged accounts, while being more aggressive with stocks in my taxable account. Those moves would leave me with the same overall stock allocation, so my risk profile wouldn’t be much different.
In some ways, I’m a cautious investor, especially when it comes to my emergency fund. I’ve got a hefty allocation to stocks—currently about 70%—but I’ve also got a year and a half of living expenses in individual Treasurys, a certificate of deposit (CD) and money market funds. I figure my fixed expenses are $5,000 a month, so that’s $90,000 in safe money sitting in my taxable account.
With current short-term interest rates over 5%, my conservative stance is raking in some good bucks, but it’s too much safety and too much taxable income. One reason it’s so much: I’m trying to save up five years’ worth of portfolio withdrawals in bonds and cash by the time I retire. At that point, with Social Security benefits of more than $2,000 a month, I reckon I’ll need just $3,000 monthly from savings to maintain something like my current lifestyle. The cash cushion I’m accumulating will protect me from a prolonged bear market.
Intuitively, you might think emergency funds don’t belong in retirement accounts, which experts say should be invested for long-term growth. After all, who wants to raid an IRA to pay bills before they retire?
But the truth is, not all good investment advice is good for all people all the time. I’m over age 59½, so I can withdraw from my retirement accounts without penalty. Moreover, the only way I’ll need to draw heavily on my emergency fund is if I lose my job or am unable to work for an extended period. In that case, I’d be in a lower tax bracket, so pulling funds from an IRA wouldn’t have onerous tax consequences.
I got the novel idea of keeping my emergency money in my IRA from HumbleDollar’s editor. He advocates keeping tax-inefficient, interest-generating investments in tax-sheltered accounts, while going heavier on stocks in taxable accounts.
My first reaction to the suggestion: What if an emergency occurs when stocks are down? I could be selling in a bear market just to buy groceries and pay rent.
But here’s the trick: Yes, in my taxable account, I might find myself selling when stocks are down. But I can swap an equivalent amount from conservative investments to stocks in my tax-advantaged accounts, so my overall asset allocation stays the same and I don’t miss any recovery in the market.
Some suggest going as low as three months of living expenses in a taxable account. I’m more comfortable with at least six months’ worth—big, unexpected expenses can still crop up even if I don’t lose my job. But that still gives me a lot of room to increase my stock allocation in my taxable account, while correspondingly boosting my cash and bond holdings in my IRAs and 401(k).
How much is at stake? Suppose I reduce my emergency savings in my taxable account to six months’ living expenses, or $30,000, from the current $90,000. I could rearrange my asset location and thereby shed $60,000 of interest-bearing cash and bonds in my taxable account.
With 5% currently available on short-term Treasurys, CDs and money funds, I’m paying a 22% income tax rate on the $3,000 annual interest from that $60,000, or $660 per year.
Yet, if I took that $60,000 and invested it in a broad U.S. stock market index fund in my taxable account, I’d pay just a 15% capital gains tax rate on the 1.4% dividend yield. That’s just $126 in taxes per year, for an annual savings of $534.
Of course, eventually I or my heirs will owe taxes on withdrawals from my traditional IRA. But that could be at a lower tax rate and, in any case, it’s potentially many, many years down the road.
William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on X @BillEhart and check out his earlier articles.
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Just for fun, let’s suppose that I trade bonds or savings [*X] getting ordinary income returns of 5% for dividends and capital gains. If, as Bill mentioned, I’m trading a [24%*A] ordinary income tax rate for a [15%*B] capital gains rate, I would only need to average [4.5%*Y] return to break even. That’s a pretty low bar although there have been 15 of the last 50 years when it wasn’t met. (Interestingly, though, there have been only 4 two year periods in the last 50 years when it wasn’t met: ) https://www.macrotrends.net/2526/sp-500-historical-annual-returns *I believe the calculation would be X*(1-A)/(1-B)=Y
Hi William,
Thanks for the article. Below is a great Boglehead’s article explaining how placing cash needs, such as an emergency fund or home down payment, in a tax-advantaged account can improve the overall tax efficiency of an investment portfolio. Be sure to read the entire article (e.g., how it works, why it works, fine points, etc.) so you understand it well. It only takes 5-10 minutes to read it. I have to admit though, I read the “How it works” section a couple of times before I really understood it. Hope this helps.
Placing cash needs in a tax-advantaged account – Bogleheads
Wouldn’t municipal bonds/bond funds in a taxable account be another approach for reasonably accessible cash and lower taxes? In the event of a drop in bond prices, a tax-loss harvesting strategy is also a nice way to accrue those useful capital losses, no?
Morningstar has excellent articles on this topic which prior to a few years ago I had not considered.
I’m always curious: Does your $5k a month cover things like car/roof replacements and the like? Or just your regular expenses such as minimum lifestyle plus some planned expenditures such as going out/vacations, etc.?
It seems to me that if you’re not covering those occasional, big-ticket, items that keeping more fully liquid might be worth the tradeoffs.
Great article, well done on outlining your thinking. I also agree with your result. Most of our cash and bond holdings are in tax-protected accounts as well.
We still have probably more cash than necessary in taxable accounts, I guess mostly so I feel like we (or my wife alone) could reach out and touch cash at the snap of a finger for whatever reason.
Great article. I wish things weren’t so complicated.
My wife likes about a year’s expenses in cash, so that’s what we do. I also would ultimately like to have a 5-year cushion in bonds and cash upon retirement. Good for you!
Interesting article, Bill. Some thought-provoking ideas.
I don’t keep a massive cash reserve — I’m not exactly wealthy anyway — and what I do keep is in my Wealthfront account making 5.27%. I have a bank credit card with a very high limit and a nice cash-back benefit, and I’ve always preferred to put unexpected expenses on the card. That way I get money back and time to pay.
I’ve had some significant medical incidents where this technique came in handy.
Informative article. We’ve thought a lot about asset location especially given all the interest income with current yields.
What has always stopped us is the psychological comfort of being able to tap a large sum of money for big changes (trading up or down residence or simply a new residence) or a new venture, etc. Having a good chunk of money trapped in IRA doesn’t make sense for us in that scenario — but keeping that flexibility of options comes at the cost of more ordinary income and therefore, higher taxes.
I can see if you’re completely settled and have no major anticipated lifestyle changes ahead then it makes sense. Maybe we will revisit further into retirement.
William, great article which highlights a lot
of good, analytical thinking on your part.
But I guess we are way more conservative
with our finances than you are.
Our emergency fund is 1 year of expenses. In a checking account that pays out minimal interest.
Is it too much?
Perhaps. But it does let us sleep soundly at night.
Like last year when we unexpectedly had to replace the entire HVAC stack in our ‘new to us’ condominium. We wrote checks to cover the whole expense and didn’t worry about it.
Now, we are gradually refilling our emergency fund for the next ‘crisis’.
Hey Winston — there are a lot of options to earn good interest on those savings. Online savings account, money market fund or, best yet, short-term Treasurys held to maturity (yielding 5%+). Make your money work for you!
Our cash stash is in our Vanguard money market traditional IRA which is linked to our bank account. This makes it available within two days.
Thanks, Bill, for a very helpful article. As per Olin’s and Jeff’s comments below, this motivates me to re-think where to hold my (possibly excessive) cash reserves.
Bill, my wife and I feel your tax pain. I
plan tomust modify the location of assets in my wife’s taxable account. She has too many investments throwing off ordinary income rather than qualified income.Always enjoy reading strategies! Articles like this is what motivates me to do something instead of just stand there.
Bill, Know that you are not alone in this dilemma. I lost some sleep over trying to maximize the “early phase” retirement cash bucket. I have a 3 year reserve (…probably too much for me). In the end, I split it 50/50 between taxable and non-taxable. I figure if I pay slightly too much in taxes, then the entire country wins.