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Increasing Returns Through Asset Allocation

By: Richard Feldman

By: Richard Feldman, CFP, MBA, AIF

You can improve your after-tax rate of return significantly by allocating your investment capital efficiently. The passing of the new tax law has made the question of where to hold assets a lot more important to individual investors because the spread between the highest tax bracket (35%) and dividends/long-term capital gains (15%) has increased. Effective placement of your investment assets can make a dramatic difference in your after tax rate of return leaving you with significantly more assets for your retirement.

For many Americans allocating investment assets across tax-deferred and taxable accounts is not a primary concern. If you are one of those individuals who primary savings vehicle is their 401K, 403B, 457, IRA, or other tax-deferred vehicle, then planning is relatively simple. You devise an asset allocation model that meets your risk tolerance (75% equities and 25% fixed income) and you invest your plan according to those parameters.

But for most individuals or families this scenario is not the norm. Individuals often have retirement accounts, IRA’s, Roth IRA’s, taxable accounts and throw in the relatively new 529 plans and you are left with the difficult decision of what goes where.

Tax-Deferral

The ability to invest on a tax-deferred basis is valuable to investors because it allows them to shelter capital gains and income from current income taxes. However, because assets differ in terms of tax liabilities they create for investors, the value of tax-deferred investing will depend upon which assets are held in the tax-deferred account. *

The asset allocation decision has become more complicated with the passing of the new tax act. The spread between the highest tax bracket rate and the capital gains rate before JGTRRA was 18.6% (38.6 percent less 20 percent). As a result of the new tax law, the spread now increases to 20% (35 percent less 15 percent), making planning for the allocation of investments across taxable and tax-deferred accounts even more important. If you reside in a state that has high local and state taxes the spread is even greater. Throw in the reduction on qualified dividends to 15% or 10% if you are in the 10 or 15 percent bracket and you can see why it has become so complicated.

Initial Steps

Every investor’s situation is different so there is no universal answer in deciding where to hold assets. Generally, the first information to gather is the breakdown of taxable versus tax-deferred investments and then decide on an asset allocation structure based on your own risk tolerance.

Take a hypothetical person who has $500,000 evenly split between a retirement plan and a taxable portfolio. Based on this person’s age, goals, and risk tolerance, he and his advisor have developed an asset allocation model of 70% equities, 10% REITs, and 20% fixed income.

The ultimate goal is to grow the total portfolio while keeping taxes to a minimum. In other word the ultimate goal is the highest total after tax rate of return.

Is the most optimal allocation to place the 30% (REITs and Fixed Income) in the retirement plan or some combination of equities, fixed income, and REITs between the two accounts?

If stocks are held inside a qualified plan or tax-deferred vehicle, the tax advantages of capital gains are lost. Any capital gains will ultimately be turned into ordinary income, upon withdrawal. On the other hand, stocks can be expected to outperform fixed income over a long term time period. The dilemma lies in putting all fixed income type assets in a tax-deferred vehicle in order to save on income taxes thus giving up some growth potential of the retirement vehicle.

Factors to Consider

Liquidity Issues: If an individual allocates most or all of his taxable accounts to equity, the investor may face liquidity problems if the value of equity declines substantially and he incurs a need to take a distribution. This can give an individual some incentive to hold some bonds in his taxable account in order to reduce the risk of liquidating equities at an inopportune time.

REITS: REIT shares deliver current income in the form of high-yielding dividend payouts, plus potential for capital gains, plus the advantage of diversification. Inside a retirement account these are all fine attributes. Inside a taxable account, however, REIT shares don’t receive the same favorable tax treatment as equities. Most REIT dividends will not be eligible for the 15%/5% rates.

Date of Death Step Up: Highly appreciated equity investments receive a step up in basis when held in taxable accounts thus allowing your heirs to receive assets with no tax consequences.

Tax Bracket: The smaller the gap between capital gains and dividend treatment and ordinary income tax rates the smaller the incremental benefit of placing fixed income and REITS in your retirement accounts.

Tax Loss Harvesting: Capital losses incurred inside your IRA are lost forever whereas losses incurred in a taxable account may be used to offset ordinary income as well as future capital gains.

Foreign Tax Credit: Both individual taxpayers and corporations may claim a tax credit for foreign income tax paid on income earned and subject to tax in another country or a U.S. possession. As an alternative, a taxpayer may claim a deduction instead of a credit. The purpose of the FTC is to mitigate double taxation since income earned in a foreign country is subject to both U.S. and foreign taxes. International and foreign funds held in a tax-deferred plan lose the ability to claim a FTC on foreign income tax paid.

Conclusion

The optimal allocation of investment assets across taxable and tax-deferred accounts combines a number of variables that need to be considered before making any decisions. Focusing on after tax rates of returns and efficient allocation of your investment assets may allow you to build a larger investment portfolio, reduce taxes, and retire earlier.

Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing Dammon, Spatt, and Zhang