Utilizing Your Tax-Sheltered Accounts

Add to del.icio.us

Most people have some investment accounts which are tax-free or tax-deferred (such as a Roth or Traditional IRA account). We believe that the best way to think of your tax-advantaged accounts is as a component of your overall portfolio rather than as a separate account where you should merely replicate the allocations that exist in your taxable accounts. As part of an asset allocation strategy, it makes sense to determine which of your assets you should hold in these tax-free accounts. This article will explain what factors you should consider when making that decision and will offer some general rules-of-thumb which should serve you well.

For the purposes of this article, we will examine the tax implications for three types of accounts: Roth IRA accounts, Traditional IRA accounts and regular taxable accounts. 401K accounts generally follow similar taxation rules to a Traditional IRA account.

Roth IRA accounts are completely tax free (if you follow the proper withdrawal guidelines). You will not be taxed on annual distributions made by your assets in the account. Additionally, you will not be charged capital gains tax on any appreciation of your assets when you eventually withdraw from the account.

Traditional IRA accounts offer the benefit of deferring tax paid until money is withdrawn from the account. You will not incur any tax liability on distributions (capital gains, dividends, etc.) made by an asset in a Traditional IRA account. However, when you withdraw the money, you will be taxed at your ordinary income tax rate. At the time of writing, the top bracket for ordinary income tax was 35%.

Taxable accounts will generally create two sources of tax liabilities. First, you must pay taxes on distributions made by the asset. Second, when you sell an asset, you will be charged a capital gains tax on the appreciation of the asset if you have held it for one year or more; otherwise you will be charged a tax at your ordinary rate on any appreciation. The federal long term capital gains tax was 15% at the time of writing.

For a more thorough discussion of the different type of IRA accounts, please refer to All About IRAs.

Objectives

Your goal is to minimize the amount of capital lost to taxes from the time of asset purchase until sale. Since most investors don’t have all of their assets in tax free-free and tax-deferred accounts; if you have a balanced portfolio, you want the type of assets which will lose the most in taxes in your tax free or tax deferred accounts.

It is helpful to remember the two sources of tax loss on your invested assets:

  1. Annual taxes on distributions made by the asset. The magnitude of these losses can be estimated by looking at the difference between pre-tax and post-tax performance as reported by index funds or ETFs in this asset class.
  2. Taxes on sale of the asset Ė either capital gains or ordinary income taxes. The magnitude of this loss will depend on how much the asset appreciates while it is held in the account. Thus, to better understand this loss, youíll need to make an estimate for the annual growth rate of the asset.

Roth IRAís are ideal because they eliminate both of these taxes if you follow the proper withdrawal guidelines. Traditional IRAís will eliminate the annual tax drag on distributions but you will need to pay taxes at your ordinary tax rate when you withdraw. Taxable accounts have a potential advantage over Traditional IRAís in the sense that you need to pay capital gains tax (which could be at a lower rate than your ordinary income tax rate) at withdrawal. Before determining where to hold various assets, youíll want to answer the following question: What are your expectations for your ordinary income tax rate and the long term capital gains tax when you withdraw money from your accounts? At Sigma, we generally think that your ordinary income tax rate will still be higher than your capital gains tax rate even in retirement due to various investment income which you will hopefully be earning at that point.

General Guidelines

Letís start with the assumption that your ordinary tax rate will be significantly higher than your long term capital gains tax rate when you withdraw your funds. Given that, here is how we think about asset allocation among the various account types.

Roth IRA

Since your Roth IRA account offers the most tax protection, you want to place assets in that account with highest expected rates of appreciation and greatest annual tax drag on distributions. An asset with a high expected rate of return would be a good candidate since you believe that the capital gains tax due on this asset will be a large amount in the future.

Traditional IRA

On the other hand, your Traditional IRA is the best spot for assets with very high annual tax drags but slower rates of appreciation. Be careful about moving highly appreciating assets into a Traditional IRA since the money will eventually be taxed as ordinary income.

Taxable Accounts

Basically, everything else. Assets with relatively high rates of appreciation and low annual tax drag are better placed here rather than in a Traditional IRA.

Historical returns and tax drags

Now, to help us determine which asset classes are best suited for each type of account, letís look at some historical performance data from some representative ETFs and Index Funds. The figures below represent average annual performance (pre- and post-tax) for the period specified. These asset classes represent the classes within the retirement portfolio recommended by Sigma (See Implementation). All data is as of 3-31-07.

Table 1: Tax Drag from Market Leading ETFs
ETF Pre-tax return Post-tax return Tax Drag Period
Spiders 500 (SPY) 8.3% 7.6% 0.7% 10 years
iShares S&P 500 Value (IVE) 8.9% 8.5% 0.4% 5 years
iShares S&P 600 Small Cap (IJR) 11.5% 11.3% 0.2% 5 years
iShares S&P 600 Small Cap Value (IJS) 11.4% 11.2% 0.2% 5 years
iShares MSCI EAFE Index (EFA) 15.5% 15.1% 0.4% 5 years
iShares MSCI Emerging Markets Index (EEM) 27.7% 27.6% 0.1% 3 years
iShares Realty Majors (ICF) 23.5% 21.9% 1.6% 5 years
iShares Lehman 7-10 year bond fund (IEF) 2.3% 0.8% 1.5% 3 years
iShares Lehman TIPS fund (TIP) 2.8% 1.1% 1.7% 3 years
Table 2: Tax Drag from Vanguard Index Funds
Index Fund Pre-tax return Post-tax return Tax Drag Period
Vanguard S&P 500 8.1% 7.6% 0.5% 10 years
Vanguard S&P 500 Value 11.9% 10.5% 1.4% 14 years
Vanguard Small Cap 11.0% 9.7% 1.3% 10 years
Vanguard Small Cap Value 10.1% 9.7% 0.4% 8 years
Vanguard EAFE Index 9.3% 8.7% 0.6% 6 years
Vanguard Emerging Markets Index 9.3% 8.7% 0.6% 12 years
Vanguard REIT 16.1% 13.9% 2.2% 10 years
Vanguard Intermediate US Treasury 6.6% 4.1% 2.5% 13 years
Vanguard TIPS fund 7.6% 5.8% 1.8% 6 years

This data gives a pretty clear picture. It seems like Treasury and REIT funds will have the highest annual tax drag but REITs have had a much higher rate of return in the past. We would expect this return premium to persist in the future since REITs are equity instruments. The Small Cap and Value index funds have relative high tax drags but these tax drags are significantly lower if ETFs are held in these asset classes. This is due to the tax advantage which the ETFs enjoy over index funds (See ETF Tax Efficiency).

Some Numerical Examples

Letís show a quick hypothetical example to demonstrate the impact of holding various assets in different types of accounts.

First, here are the general assumptions that we will operate under:

  • Initial investment in each asset $100
  • Holding period of 30 years
  • Ordinary income tax rate of 30%
  • Capital gains tax rate of 15%

Letís consider the situation where you have three types of assets which you will purchase. These assets have different pre- and post-tax returns as described in the following table.

Table 3: Return Characteristics of Assets
Asset Pre-tax return Post-tax return
Treasuries 6.0% 4.0%
REIT 10.0% 8.0%
Emerging Markets 10.0% 9.5%

Based on our earlier discussion, we would expect the REIT to be the best candidate for the Roth IRA account due to the high rate of appreciation and the high tax drag (2%). Now, letís see what the post-tax performance would be under our assumptions. Note that we assume that the annual tax drag is paid from the account which incurs the tax. So, in effect, the asset will appreciate at the post-tax return rate. The following table shows the post-tax value of the investments depending on the type of account which holds the asset.

Table 4: Hypothetical Final Account Values
Asset Taxable Traditional IRA Roth IRA
Treasuries $291 $402 $574
REIT $870 $1,221 $1,745
Emerging Markets $1,309 $1,221 $1,745

We see that there is a big difference in final value depending on the account used. The REITís final value is greatly reduced when held in the Traditional IRA or Taxable account. As we mentioned earlier, this is due to the high rate of appreciation and the large annual tax drag on that asset. One key thing to notice is that the emerging market fund actually performs better if held in the taxable account rather than a traditional IRA. This is due to its relatively low annual tax drag and rapid rate of appreciation. The ordinary income tax in Traditional IRA account creates a greater tax burden than the savings of the annual tax on distributions. Thatís a key lesson from the analysis: Be careful about putting rapidly appreciating assets into a Traditional IRA account.

One question that you might have is: how big must the annual tax drag be for it to make sense to move an asset with a 10% annual return into a Traditional IRA? This can be easily calculated in Excel. It turns out that for tax drags of less than 0.75%, it makes sense to leave these assets in taxable accounts when you use our assumptions. So, as a rule of thumb, you should probably feel good about holding assets in a Traditional IRA account when the tax drag is greater than 1%.

Specific Funds

As a recap, here are some of the specific asset classes that we believe are well suited to various types of accounts:

  • Roth IRA Ė REITs
  • Traditional IRA Ė Treasury funds, value and small cap index funds
  • Taxable accounts Ė Everything else but especially emerging markets funds and equity ETFs

Hopefully, youíve gained a better understanding of the implications of taxes on your investments. By being smart about where you place various asset classes, you can save yourself significant amounts of money in the long run.