This article discusses personal investment portfolio asset allocation and some considerations about where to hold different classes of financial assets from the standpoint of more optimal taxation.
As you move your cash, bond, and stock financial assets into lower cost, more broadly diversified investment mutual funds and/or ETFs, you should also consider how to “locate” your investment asset allocation with respect to more optimal taxation. This article will also discuss some ideas about where and how to hold your cash assets and how to make emergency cash available. (Note that you can reach us by using the contact form below.)
First, we presume that you have already properly assessed your investment risk tolerance. Using knowledge of your investment risk tolerance, we also presume that you have decided upon an appropriate asset allocation across the primary cash, bond, and stock asset classes. Then, the next question is how you will split your cash assets, fixed income assets, and equity assets between your taxable retirement investment accounts and your tax-advantaged retirement investment accounts, including traditional IRAs, Roth IRAs, traditional 401ks, Roth 401ks, and other such tax-advantaged retirement accounts.
Post-Credit Crisis Notes Concerning:
Asset Allocation Strategies
NOTE: The best individual financial planning practices are durable and should not change due to economic or securities market cycles or crises. This article was written before the credit crunch crisis, but requires no changes. The additional comments in this box emphasize the enduring wisdom of the original, detailed tax optimization discussion that follows.
You and your family’s particular tolerance of or aversion to investment risk drives your long-term asset allocation strategy and your exposure to asset classes with different expected risk and return characteristics. In addition, the differential tax characteristics of various asset classes and the different treatment of taxable investment accounts versus tax-advantaged retirement investment accounts creates valuable opportunities to optimize your overall investment portfolio returns from an after-tax point-of-view.
As long as short-term capital gains tax rates and long-term capital gains tax rates differ and as long as the taxation of returns on certain types of investment securities differs, e.g. taxable bonds versus municipal bonds, then there will be opportunities to pay lower taxes overall related to your total investment portfolio. Merely by holding certain types of assets in certain types of accounts, you can reduce your overall tax payments and thus increase the value of your retained investment portfolio over time. The financial crisis has not affected the logic of this article. However, changes in tax law and in the differential tax treatment of capital assets and account taxability over time can change the long-term value of your effort to optimize your personal asset allocation from a “tax location” perspective.
Deciding which investment assets to hold in various types of taxable investment accounts versus tax-advantaged or tax-deferred retirement accounts is known as the “asset location” decision.
There can be substantial confusion on the part of individual investors and many investment advisors as to the best location for assets from the standpoint of taxation over the long-term. Simply put, in deciding on your investment asset location, the question is whether you should hold your stocks, bonds, and/or cash in taxable and/or tax-advantaged retirement accounts. To summarize the investment research literature, the academic consensus is that you should prefer to hold your stock or equity assets in your taxable accounts and you should prefer to hold your cash and fixed income assets in your tax-advantaged accounts.
The primary reason for this is that long-term federal capital gains tax rates historically have been substantially lower than short-term capital gains tax rates and ordinary income tax rates. Even though stocks tend to appreciate more quickly than bonds, taxation on equities can often be deferred for a very long time. In addition, when capital gains taxes must be recognized on equity asset transactions, very often these gains will be subject to lower federal long-term capital gains tax rates.
[Note, of course, we also hope that you intend to lower investment fees significantly, if you have not done so already. You can invest your equity, bond, and cash assets in very broadly diversified, passively managed index mutual funds and index ETFs with very low costs, very low turnover, and very low taxes, as well.]
Fixed income / bond assets and cash money assets usually yield income that must be recognized regularly and must be paid at generally higher ordinary income tax rates.
Including inflation which has averaged 3% annually, stocks have returned about 10% per year over the past 80 years. Alternatively, expressed in real dollars or constant purchasing power dollars without inflation included, this means that stocks have yielded about 7% annually over the long-term. For these many decades, high grade longer duration corporate bonds have yielded about 5.5% to 6% including inflation and about 2.5% to 3% without inflation. Cash has yielded somewhat short of 4% with inflation and somewhat less than 1% in real terms without inflation. (For more information about long-term financial asset returns, see these Market Risk Premiums articles published on our sister website, The Skilled Investor.)
For bonds, only a small part, if any, of longer duration fixed income yields are in the form of capital gains, which could be subject to more favorable long term capital gains tax rates. Cash does not generate favorable long-term capital gains at all. Despite the lower yields of bonds and cash, their income is usually continuous and taxable in the short-term. Particularly if you have a relatively high combined state and federal marginal income tax rate, you can lose a substantial part of your bond and cash income to taxation without the tax shelter provided by tax-advantaged retirement plans.
In contrast, even though equities have substantially higher yields, a substantial proportion of these returns can be deferred, which avoids near term taxation. Furthermore, if properly managed, most often these taxable equity returns can be taxed at lower federal long-term capital gains tax rates, when needed.
Combined, these factors mean you can net more after taxes by holding your equities investment assets in taxable accounts and by holding you bond and cash assets in tax deferred retirement accounts.
In the research studies that were mentioned above, investigators analyzed a wide range of portfolios with different asset allocations and different asset tax locations. The objective of these studies was to determine what is optimal from a tax location standpoint, and uniformly they reached the general conclusion to put equity assets subject to long-term capital gains into taxable accounts and bond or fixed income assets into tax-advantaged accounts.
Cash and cash equivalents, which tend to earn less than bonds are “located” in the middle from a tax location or tax optimization standpoint. If your particular asset allocation would me that any cash or bond assets would be held in your taxable accounts, the assets should be cash assets, because their taxable yields are usually lower than bonds. (See the related section below about cash holding entitled “Emergency cash management and your allocation of cash assets to tax-advantaged retirement accounts.”)
Your asset allocation and the total amount of assets you have in taxable versus tax-advantaged accounts combined with your asset allocation will determine whether some of your cash, bond, and/or equity assets end up being held “less optimally” from a taxation standpoint in taxable or tax-advantaged accounts.
To be clear, however, the research demonstrates that the asset allocation decision dominates the tax location decision. This means that you do not change your asset allocation decision, because of tax considerations. Instead, you hold to your asset allocation despite tax considerations. (Note, however, there may be alternative investment vehicles that address particular needs. For example, persons with very high federal, state, and local marginal income tax rates and a relatively high allocation toward bonds may find that their bonds would fill their tax-advantaged accounts and overflows into their taxable accounts. When this happens, they might benefit from holding municipal bonds rather than taxable bonds.)
Obviously, over time your assets in taxable versus tax-advantaged accounts may grow at differential rates. In addition, over time you might decide to change your asset allocation between asset classes. However, asset allocations tend to be relatively stable because they are tied to your relative investment risk tolerance, which tends to be more stable. Therefore you preferred asset allocation percentages do not have to change over time, although they may.
As time goes on, you may need to make rebalancing adjustments to maintain your asset allocation within the percentages and tolerances that you wish to maintain. This might cause some shifts in the which asset classes are held in accounts with different taxability. Nevertheless, your asset allocation decision still would drive everything.
An example of how the personal asset allocation and asset location decisions are combined
Your asset allocation decisions and your asset location decisions can be mapped onto a line that goes from 0% to 100%. First, total the cash, bond, and stock financial assets that you hold in your taxable and tax advantaged accounts, and then determine the proportions that are in taxable accounts or tax-advantaged retirement accounts.
In this example, assume that you presently hold 60% of your total cash, bond, and stock financial assets in taxable accounts. In addition, assume that 30% of your total assets are held in traditional tax-advantaged accounts, and that 10% of your total assets are held in Roth tax-advantaged accounts.
Using the 0% to 100% line illustrated in the graphic below, mark the range from 0% to 60% as your taxable assets. Mark 60% to 70% as your Roth tax-advantaged retirement assets. Finally, mark 70% to 100% as your traditional tax-deferred retirement assets. (Below, we will discuss why we have chosen to place your Roth retirement assets before your traditional tax-deferred retirement assets, as you move up this line.)
Next, on this same line we will overlay your asset allocation. Let us assume that you have chosen an overall asset allocation of 70% to stocks and equity assets, 20% to bonds and fixed income assets, and 10% to cash and cash equivalents. Along this 0% to 100% line, your individual stocks, equity mutual funds, and stock ETF assets would be assigned to the left hand side of this line or from 0% to up 70%.
Because bonds tend to be higher yielding than your cash, you would always assign your fixed income assets to the right hand side of this line. Since you have decided that you want to have a 20% bond asset allocation, then your bonds would fill in the range from 80% to 100%. Finally, your cash would fill in the space in the middle that remains between equities and bonds. In this case, you cash would be “located” from 70% to 80% along this line.
Now, what is the result? Of your 70% allocation to equities, 60 percentage points would fill up your taxable accounts entirely and the remaining 10 percentage points would overflow into your tax-advantaged retirement accounts. In particular, your 10 percentage point overflow of equities would be invested in your Roth retirement accounts. Therefore, in this example, all of your Roth account assets would be equities, since 10% of your total assets currently are equities.
For the remaining 30% of your total assets, which are traditional tax-advantaged assets in the 70% to 100% range of this line, these would be where you put your bonds and cash. Therefore, your 20% fixed income asset allocation and your 10% cash asset allocation would be held in your traditional tax-advantaged retirement accounts.
Why would equities be allocated into Roth retirement accounts versus into traditional tax-advantaged retirement accounts.
If your equity asset allocation is sufficiently high that some of your equity assets would be held in tax-advantaged accounts, then they would be invested in Roth accounts, if you have Roth account assets. Because equity assets historically have appreciated more quickly than bonds or cash, it is preferable for your stock assets to be in Roth accounts, which would not be subject to future taxation. Since traditional tax-advantaged accounts eventually would be taxed at ordinary income tax rates, you would prefer that these accounts would grow more slowly, while you would prefer that your Roth accounts would grow more quickly in relative terms.
Also, note one caveat about the example presented above. If your asset allocation and/or taxable versus retirement asset proportions were different and your equities do not entirely fill your Roth accounts, then you would fill the remainder of your Roth accounts with your bond assets rather than your cash assets. This is simply because you would prefer to have higher growth fixed income financial assets in your Roth accounts versus slower growing cash assets.
In addition to normal differences in investment asset class growth rates, there are some other personal estate planning reasons that could favor placing higher growth assets into Roth retirement accounts.
Roth retirement accounts have some very significant advantages over traditional tax-advantaged accounts for estate planning purposes. If a family’s financial model indicates that there is a good possibility that they will still have some tax-advantaged account assets at death, then those should be Roth tax-advantaged account assets, whenever possible.
US tax laws and IRS regulations require mandatory withdrawals from traditional retirement accounts after age 70 and 1/2. These mandatory withdrawals might be adequate to meet your expense needs in retirement without having to touch your Roth retirement account assets. During your retirement, your Roth accounts would not have mandatory withdrawal requirements. (Obviously, in retirement you would still have the option to withdraw either traditional retirement account assets and/or Roth retirement assets.)
Furthermore, your Roth accounts could be inherited by your children, and these inherited Roth assets could also grow tax free within the inherited Roth account over the expected life of the child. During your child’s life there would be certain mandatory withdrawal requirements that apply to them and taxes would apply to these mandatory withdrawals. This means, for example, that a child inheriting a Roth account at age 40 could perhaps enjoy another 50 years of tax-free investment growth with an income stream along the way from the mandatory taxable withdrawals. Traditional tax-advantaged retirement accounts do not provide these very significant estate planning benefits.
Emergency cash management and your allocation of cash assets to tax-advantaged retirement accounts.
Some people become concerned, if their combined asset allocation decision and asset location decision means that all their cash would be held more optimally from a tax standpoint in their tax-advantaged retirement accounts versus in their taxable accounts. Furthermore, some people also may be concerned about how much cash to hold in a taxable account for “emergency” purposes, despite whether such taxable cash holdings are less optimal from a tax location standpoint.
Often these emergency cash and tax issues are of lesser importance than they would seem at first. A decision can be made simply to keep “X” expense months of cash in a taxable account and to pay the taxes, even though this allocation might less than optimal from a tax savings standpoint. In addition, real estate lines of credit or other unused and available debt lines can be taken into consideration, which perhaps might reduce the amount of emergency cash that one desires to hold in taxable accounts.
By way of example, if your monthly expenses were $6,000, you might want to hold 6 months cash or $36,000 in a taxable savings account. Assuming that you could earn the average historical pre-tax return of 4% annual interest rate on these $36,000 dollars, your taxable savings account would yield $1,440 in additional taxable income. If your total marginal federal income tax rate and state income tax rate was 26%, then you would pay about $375 more in federal and state income taxes annually to hold this cash in a taxable account versus in a tax-deferred retirement account.
To optimize your asset tax location, you could invest your cash in a tax deferred retirement accounts and use off-setting transactions to raise cash money for emergencies.
If you did happen to have a major financial emergency, you could make some offsetting transactions to free up the needed emergency cash from your retirement accounts. In effect, cash can be “moved” out of your tax-deferred accounts when needed by selling taxable equity assets for the cash that was required and then “replacing” those assets in your retirement accounts. You would replace the assets that you sold in you taxable accounts by buying similar assets in tax-advantaged retirement accounts using the cash that you held in your tax-advantaged accounts.
Of course, these offsetting transactions could trigger capital gains tax recognition related to your equity asset sales from your taxable account sales. Over the long-term, the affects usually are quite small particularly since true emergencies consuming significant amounts of cash are relatively rare. Of course, you also might need to make overall adjustments to your asset allocation, given the emergency use of the cash. Furthermore, be aware of IRS wash sale tax rules that might apply, if you buy substantially identical investments in tax-advantaged retirement accounts, when you also sell them in taxable accounts.
Finally, concerning a smaller cash emergency fund, you still might chose to hold some amount of cash in a taxable account for ready access — perhaps a few thousand dollars or more. There could be other benefits to doing this. You may find a bank that will arrange for your savings account cash (earning reasonable interest we hope) to act as over-draft protection to your linked checking account. With such an arrangement the higher taxes associated with holding a small amount of emergency cash in taxable accounts might be offset sometimes by preventing those nasty overdraft events, when you make a mistake and bank charges mount rapidly.
See: Pasadena Investment Advisors >>>
Pasadena CA Financial Advisors
Larry Russell, Managing Director
MBA – Stanford University, MA – Brandeis University, and BS – M.I.T.
Lawrence Russell and Company Pasadena, California 91103
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