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Seeking Shelter

William Ehart

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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