I wrote a post a while back titled Financial Literacy in One Sentence. This was that sentence:
Financial Literacy is spending less than you make, on the things that you value, and saving and investing the rest in low-cost, diversified index funds selected based on your investment time horizon.
I still think it holds up. And if you implement that sentence you are going to be in good shape. This post is about optimizing, which means it will improve your outcomes a bit compared to “just” implementing that sentence. So it’s not necessary to live your “good life”, but is a way to increase your total returns over time for those who want to make the effort.
Which Asset Classes in Which Type of Accounts?
Choosing your Asset Allocation (influenced by your risk tolerance) is the biggest factor in your long-term return. Then investing in low-cost, diversified index funds selected within those asset classes is the next biggest factor. The next factor for most folks is taxes. While it’s a much smaller factor than the first two, it can still make a meaningful difference in your long-term return. Choosing whether to invest in traditional (pre-tax), Roth, or taxable brokerage accounts (and how much in each) is a big part of optimizing around taxes. This post takes that a step further by discussing which asset classes to hold in which type of account.
As with everything in personal finance, individual circumstances will vary, but the following will be true for most folks. Certain asset classes are better placed in certain kinds of accounts because of the tax consequences associated with both the asset class and the account.
To be clear, this is not suggesting that you have each of those asset classes only in those types of accounts. Rather it’s saying that you want to put enough of that asset class in that account until you meet your overall asset allocation to that asset class. Because the balances you have in each type of account will not be distributed “perfectly” to exactly match your overall allocation, at least some of the asset classes will be present in more than one type of account.
Let’s say your desired asset allocation is 40% U.S. Stocks, 30% International Stocks, 20% U.S. Bonds, and 10% Cash (this is just an example, not a recommendation). In your taxable account, you would want to invest in U.S. Stocks up until the point you hit 40% of your overall investable asset balance. If you have enough in your Taxable account that it exceeds the 40%, then after investing up to the 40% in U.S. Stocks you would move on to other asset classes to invest in (more on that in a minute). On the other hand, if you don’t have enough in your Taxable account to get to 40%, then you will want to invest in U.S. Stocks in some of your other types of accounts until you get to 40%. The same is true for the other asset classes and types of accounts.
For account types where you have more money in them than you can invest in the first asset class and stay within your asset allocation guideline, you would then move on to additional asset classes. This is the suggested order to invest in in each type of account if you have additional money to invest after you’ve met your allocation in the first asset class.
Going back to our example, let’s say that you only have enough money in your Taxable account to get to 30% U.S. Stocks. In that case, your entire Taxable account would be in U.S. Stocks and then you would want to invest enough in your Roth and/or HSA accounts to make up the additional 10% of your asset allocation to U.S. Stocks. If the combined amount in your Taxable and Roth/HSA accounts wasn’t enough to get to 40%, then you would move on to pre-tax for the remainder.
On the other hand, if you did have enough in your Taxable account to get to 40% in U.S. Stocks, then the next amount in your Taxable account would get invested in International Stocks. If there was still money left over after meeting your International Stock allocation of 30%, then you would move on to Cash, Bonds and REITs (the order of those three isn’t particularly important in this account).
Money is Fungible
When thinking about your asset allocation, lots of folks (to keep it simple) essentially have the same asset allocation in all of their different types of accounts (taxable, pre-tax, Roth, HSA). But here’s the thing to remember: money is fungible. It doesn’t matter (in terms of your asset allocation at least) which account the 10% in cash is in. As long as your overall allocation across all of your accounts is 40/30/20/10 (in this example), you’re good. Which means that if there is another reason (like taxes) to allocate them differently, you should. Because different types of earnings are taxed differently in different types of accounts, it can make sense to tailor your allocations to how the taxes are determined.
Taxable Account Tax Rates
- Interest on Cash and the distributions from Bonds and REITs are taxed as ordinary income at your marginal federal tax rate (and in most states, at your marginal state tax rate as well). For many folks, that means 22% (or even higher) at the federal level.
- Ordinary dividends and short-term capital gains from stocks (both U.S. and International) are also taxed at ordinary income rates.
- Qualified dividends and long-term capital gains from stocks are taxed at (preferential) capital gains tax rates. That rate is typically 15% at the federal level, although depending on your total taxable income can sometimes be 0% (and the maximum is 20%). They key is that this will always be a lower rate than your ordinary income tax rate. In addition, long-term capital gains are not taxed until you actual incur them by selling shares. Until that point, they are tax-deferred (and the gains are referred to as “unrealized gains”. (Note that most states that have an income tax still tax qualified dividends and long-term capital gains as ordinary income, so no additional savings at the state level.)
So how does that translate into the recommendations above? First, since gains from stocks are taxed at a lower rate in your Taxable account than Cash, Bonds or REITs, you would rather “fill up” your Taxable account with Stocks first. Since U.S. Stocks (currently) have a dividend yield in the 1% – 1.5% range and International Stocks (currently) have a dividend yield in the 2.5% – 3.5% range, you want to choose U.S. Stocks first because they will create less taxable (ordinary dividend) income. Then if you still have money left over after meeting your U.S. Stock allocation, then your next investment would be International Stocks. If you then still have money left over, then you could move to Cash, Bonds and REITs.
Traditional (Pre-Tax) Account Tax Rates
In traditional (pre-tax) accounts, all gains are tax-deferred, so you don’t pay anything right now. But when you eventually withdraw the funds, all gains (whether it’s interest on cash, distributions from bonds or REITs, ordinary dividends and short-term capital gains from stocks, or long-term capital gains) will be taxed as ordinary income (again, for many folks reading this, that’s 22% at the federal level). There is no special treatment based on the types of gains like in your Taxable account, it’s all just taxed as ordinary income. Which means you want as little of your designated allocation of stocks in your pre-tax accounts as possible because you’ll lose the preferential tax treatment on those gains. But the interest on Cash and the distributions from Bonds and REITs will be (eventually) taxed as ordinary income no matter which type of account it is in (except HSA), so you are not “losing” any tax advantages by investing in them in a pre-tax account. (There’s also the advantage that these asset classes tend to grow “slower” than Stocks, so ultimately you will have lower Required Minimum Distributions to contend with.)
Roth Account Tax Rates
Like traditional (pre-tax) accounts, any gains in your Roth account are tax-deferred (in the sense that they aren’t taxed when you receive them). But in reality, they are tax free, because withdrawals from your Roth accounts are not taxed at all (not at ordinary income tax rates, not at capital gains rates; simply not taxed at all). This means that you typically want to invest in asset classes with the most growth potential (since all the gains will be tax free). That asset class would be Stocks (both U.S. and International). Again, if you meet your allocations for U.S. and International Stock and still have money left to invest in your Roth, then you certainly can move on to REITs, Bonds and Cash (in that order as that’s the order from greatest to least expected return).
HSA Account Tax Rates
While HSAs are triple-tax advantaged so in most respects are even better than Roth accounts, for this asset allocation discussion they act just like Roths since your gains are never taxed (as long as you use withdrawals for qualified medical expenses). In the “worst case” scenario that you end up with more money than your accumulated and future medical expenses (which is a fantastic scenario), then after age 65 any money that is a non-qualified distribution is taxed (but with no penalty) so acts just like a traditional IRA. Which means that you want to choose assets just like you do for Roth: Stocks first (if you are delaying reimbursement and using this as a stealth retirement account), then REITs, Bonds, and Cash if you’ve met your allocation.
Note that there are some nuances to this discussion if you are retired and needing to distribute from these different types of accounts. For retirees who have not yet reached age 59.5 (and especially for very early retirees), you need to make sure you aren’t going to exhaust your taxable account before age 59.5 if you follow this strategy (because your taxable balance will be more volatile with this strategy). While there are ways to access your tax-advantaged accounts before age 59.5 without penalty, it does become more complicated.
Is this going to be a life-changing difference if you do this? Probably not. But can it add up to a meaningful difference over time? Absolutely. And the longer this strategy is in place, the more those differences compound (pun intended).
Some folks may be worried about what happens when they need to sell/distribute some money from one of these types of accounts (typically Taxable, but could be any of them). The strategy is pretty straightforward. Let’s say you sell $10,000 worth of U.S. Stocks in your Taxable account to take a great vacation. This will lower your overall allocation to U.S. stocks to something less than the desired 40%. But all you have to do is then purchase additional U.S. Stocks in one of the other type of accounts (preferably Roth or IRA if it’s feasible) by selling the now overweight asset classes and purchasing U.S. Stocks to get back to your 40% allocation. Because you can sell in your Taxable and then buy (rebalance) in another type of account at essentially the same time, you are not “timing the market” or particularly worried about “selling low.” Because you are selling and buying the same amount of U.S. Stocks (in this example) at the same time, it’s a wash. You end up owning the same number of shares at the same price as you did before you sold in your Taxable account.
Again, personal finance is personal. So there are likely some situations for some folks where this might not be the best strategy. But, for most folks, this should result in better long-term, after-tax returns.
Fisch Financial 