The old adage in the investment world is that it is not what you make, but what you keep that counts.  Investors often overlook the ultimate deflator of portfolio returns – the taxman. An astute global asset allocation should be the number one priority for investors.  However, there are preferred ways to distribute this asset allocation over the spectrum of taxable and tax-deferred accounts to minimize the tax bite.

How to Allocate Holdings to Take Advantage of Tax Rules:  

The general rule is that more conservative and income-oriented assets, such as bonds and fixed income, should be allocated to tax-sheltered accounts (TSAs) first.  Equity, whose sale will taxed at capital gains rates, should be held in taxable accounts first. That is because:

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  • Preferential capital gains rates on sales of securities, generally 15%, are only available in taxable accounts.   All distributions from TSAs, even those based on stock holdings, will be taxed at ordinary income rates, which are normally higher.  

  • If bonds are held in a taxable account, the interest payments will be taxed at ordinary income rates, typically at your highest marginal rate.  If bonds are held in a TSA, you avoid the present taxation. It is common to have a lower marginal tax rate when you begin to withdraw from your IRA account, as that often occurs at the age of retirement.

  • Dividend taxation rates for stocks held in taxable accounts are currently 15-20% at the federal level, or 23.8% for high-income taxpayers when the Medicare surcharge is included.  This is not applicable for equity held in TSAs.

  • Equities are generally more volatile investments, involving a greater chance of loss.  In a taxable account, any capital losses can be used to offset capital gains. Capital losses can also be used to offset $3,000 of regular income annually, and any unused losses can be carried forward. Losses are not treated this way in TSAs.  

  • Equity held in a taxable account will enjoy a step up in basis to the date of death value upon the holder’s passing.  This will eliminate unrealized gains and potential large capital gains taxes that may exist, especially for positions held for a long time period.  This benefit does not exist in TSAs.

Order of Account Priority for Placing Equity:

While your target asset allocation should drive the process, to the extent possible allocate your taxable account more to equities and your TSA accounts more to fixed income.  Given the risk/return profile of the two asset classes, they should not be expected to perform in unison. In bull markets, the TSAs and their fixed income holdings may lag, but during market volatility may be more resilient. The order of equity priority by account is as follows:

  • Taxable Accounts – take advantage of lower capital gains and dividend taxation rates and hold maximum equity here, allocation permitting.

  • Roth IRA – Roth accounts are funded with after-tax contributions, and the withdrawals will come out tax free.  Equities should appreciate more over the long-term than fixed income, so you effectively shelter more from the taxman.  

  • 529s – these are funded with after-tax money.  However, the time frame may be shorter than of a Roth IRA, as college tuition typically precedes retirement.  You will want to combine growth with caution that the funds will be there for your child’s education.

  • Traditional Retirement  (IRAs, 401Ks) – for the reasons elaborated on above, these accounts should primarily hold fixed income, absorbing whatever equity overage is needed to reach your target asset allocation.

  • IRA Beneficiary Designated Account (BDA) –the timetable for withdrawal starts at the end of the first year after death and inheritance, unlike other traditional IRAs.  The withdrawal timetable is accelerated and increases your ordinary income. To minimize this, fixed income is the preferable option.

Investors should place utmost importance on an astute global asset allocation.  However, minimizing the taxman’s impact on your portfolio will help maximize returns and allow you to reach your investment goals.

Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.

For 25 years, Point View Wealth Management, Inc. has been working with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals.  Click here to contact David Dietze, John Petrides, Claire Toth, Donna St.Amant, and Elaine Phipps, or call 908-598-1717 to learn more about Point View Wealth Management, Inc. and how we can help you and your family meet your financial objectives. To sign up for our complementary commentaries and newsletters, e-mail us at firm@ptview.com.

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