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After an overall asset allocation is determined, minimize the impact of taxation on your investments by locating more tax-efficient holdings (low dividend, high capital gain, tax exempt and index funds) in your taxable accounts and least tax-efficient (high dividend and high interest bearing) holdings in your tax-deferred accounts. For example, if your overall asset allocation were 50% bonds and 50% stock, you would consider having your IRA hold all the bonds and your taxable brokerage account hold all the stocks. Since most people do not have equal amounts in each account and all stock strategies are not equivalent, it is not that easy. You will see the principle will be useful in efficiently allocating across investment vehicles.
Rebalancing your portfolio can also result in tax consequences. If a trade would result in a capital gain, executing it in your tax-deferred account will not have an immediate tax event. Taking losses in your taxable account will create immediate tax deductions. Paying attention to where you trade will result in substantial tax savings over the life of your investment portfolio.
Maximize your tax-deferred retirement contributions
The goal of wealth management is to achieve a preferred standard of living through time. We invest in education to generate higher future earnings (a better life for you and your family). We promise some of our future earnings in a home mortgage so we can have a higher standard of living today (smoothing consumption over time). Saving for retirement is giving up some spending today to supplement a lifestyle after we retire, and our labor income is unavailable.
Retirement income can be generated from multiple sources. Liquidating real assets (i.e., selling, downsizing, or taking equity out of a home), principal and income from after-tax investments and pre-tax retirement plans (401K, 403b, IRA, etc.). These qualified pre-tax retirement plans have a unique set of incentives. If there were a set of commandments for investing, maximizing qualified tax-deferred retirement contributions would be number one. Some of the reasons are:
I should note that I am not a fan of Roth plans. It isn’t a no-brainer. One might think it makes sense when you are in a low tax bracket and the immediate tax savings of a tax-deferred plan is negligible. The benefit is that many years later the accumulation will be tax free. That makes some sense, especially for disciplined savings. However, if you are in that low a tax bracket, taxes on dividends and capital gains will be initially negligible. Why deal with the constraint of waiting until retirement to access the accumulation when it will be more likely that you will need the money sooner for a down payment on a house, education expenses or a business venture. The latter two motivations will add human capital and increase income faster. In this case, accumulating wealth sooner and having a bigger tax problem is a good thing! In a high tax bracket, a traditional tax-deferred plan with the immediate tax saving generally dominates the Roth alternatives. Paying the tax now and investing in a Roth plan is forgoing both the current tax savings and future tax options of managing to lower rates or never paying the tax at all. Examples of never paying the income tax include charitable contributions directly out of the plan that also count toward your required minimum distribution; using the plan to pay tax-deductible medical expenses when they are likely to be high; outliving your plan to be rolled over into your heirs plan and when the investment ends up worth less in the future. This last possibility is more likely for those converting to a Roth near or in retirement. Paying taxes in advance on a gain at the ordinary rate really hurts when the reinvestment ends up in a loss. Like all options, the tax option is worth more alive than dead!
Stanley J. Kon is Chairman of Ripsaw LLC where he oversees research, education, and product development. He also is the editor of the Journal of Fixed Income. Dr. Kon has written extensively in the areas of investment management, performance measurement, asset pricing, statistical models of stock returns and mortgage-backed securities. He has published articles in the Journal of Financial Economics, Journal of Finance, Journal of Business, Journal of Empirical Finance, Journal of Fixed Income and Financial Analysts Journal. He served as the J. B. Fuqua Visiting Professor of Finance at Duke University’s Fuqua School of Business where he taught courses in fixed income securities and risk management. He was also a Visiting Professor at New York University’s Stern School of Business where he received the Executive MBA outstanding teacher award. Prior to that, Stanley was a principal, executive vice-president, director of research and co-director of the investment management group at Smith Breeden Associates, Inc., an institutional investment management company. Prior to that, he was a Professor of Finance at the University of Michigan from 1982-1997. Prior to 1982, Professor Kon served on the faculties of New York University, the University of Chicago and the University of Wisconsin at Madison. Dr. Kon has also served on several bank and holding company boards and as a consultant to government, business and financial institutions. Dr. Kon received his BS in Chemical Engineering from the Lowell Technological Institute, his MBA in Finance and Economics from St. John’s University and his PhD in Finance from the State University of New York at Buffalo.