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Tax Tips
The Inside-Out Story - January 2008
Richard Scrivanich - Partner
If you do all of your investing inside of a tax-deferred retirement plan such as an IRA or a 401(k), “asset location” won’t be an issue. You can determine how much to invest in stocks, how much in bonds, and so on, then implement your asset allocation within the plan.
Many people, though, invest through a taxable account as well as inside a retirement plan. If that’s the case, you should decide which investments to hold inside the retirement account and which investments you prefer to keep on the outside in a taxable account. There are various strategies you can use.
The balanced approach
Some advisors favor a balance between taxable and tax-deferred accounts, with similar allocations on each side. With this plan, an investor has several asset classes in the taxable account, so it’s possible to take losses on the taxable side when a given asset class falls. Capital losses may be used to offset the tax on capital gains while net capital losses in excess of gains may be deducted up to $3,000 per year.
On the other hand, assets that have appreciated can be sold to maintain your allocation. With a balanced strategy, you can re-set your portfolio by taking gains inside the tax-deferred account, which will defer tax on those gains.
Tax-efficient tactics
Another strategy is to try to place tax-inefficient asset classes inside a retirement plan. Such assets generate high current taxes, which will be deferred inside of the plan. Meanwhile, tax-efficient assets can be held in a taxable account. They won’t generate significant taxes, so there may be no reason to place them inside a tax-deferred plan.
Real estate investment trusts, (REITs), for example, might go inside retirement plans, since they typically pay substantial dividends. Most REIT dividends are taxed as ordinary income, at rates up to 35% under current law. Therefore, considerable shelter is possible if you hold REITs and REIT mutual funds in a tax-deferred plan.
Small-cap mutual funds may have substantial turnover, generating highly-taxed short-term capital gains. Inside a tax-deferred account, the tax on such gains will be deferred.
Taxable bonds also may fit well inside a retirement plan because the tax on the interest can be deferred. That’s especially true for junk bonds, which have more taxable interest to shelter.
Outside choices
While you might attempt to invest in the above asset classes in a tax-deferred retirement account, other investments may work well on the outside, in an account where you’ll pay tax each year.
Large-cap domestic equities can be very tax-efficient, especially if you invest through index funds. Large companies are likely to pay dividends. Under current law, the tax rate on most corporate dividends is now 15% (5% for low-bracket taxpayers). Therefore, stocks that pay substantial dividends probably should be held outside of a retirement plan. If such stocks are held inside a plan, the dividend income eventually will be fully-taxed on withdrawal, and you will get no benefit from the special low tax rates.
Municipal bonds belong on the outside because the interest income is already tax-exempt. Many high-income taxpayers are better off in municipal bonds rather than taxable issues.
International stocks and international stock funds also may work best in a taxable account. Investors who pay foreign taxes can get a tax credit, but that tax credit will be lost if the foreign equities are held in a tax-deferred account. You’ll wind up paying tax twice. After paying tax upfront to the foreign government, you’ll eventually pay the IRS, too, when the money is extracted from the tax deferred plan.
If you have any questions regarding the above discussed topic, or any other tax matter, please feel free to give me a call at (562) 698-9891.
Return to Current Tax Tips
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Do not duplicate or distribute without permission. All information in this
article is for informational purposes only.
Some of the articles included here were written in a prior
year or before a current tax law change. Therefore some of the information in
the older articles may not still be valid. Any dollar thresholds indicated
relate only to the year for which the article was written and could be different
for the current year. Please discuss with us your personal situation before
acting on any of the information provided. If you have any questions,
please give us a call at (562) 698-9891.
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