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Traditional IRA accounts offer the benefit of deferring tax paid until money is withdrawn from the account.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.
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:
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.
Taxes on sale of the asset - 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, you'll need to make an estimate for the annual growth rate of the asset.
Roth IRA's are ideal because they eliminate both of these taxes if you follow the proper withdrawal guidelines. Traditional IRA's 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 IRA's 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, you'll 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.
Let's 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.
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.
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.
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, let's 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.