Lots of investors have good reason to dread tax time this year because they're facing hefty capital-gains taxes on the mutual funds in their taxable accounts. And all those tax bills may give folks excellent reasons to reflect on what (if any) strategy they have for slotting investments into taxable or tax-deferred accounts.
Say you've got a decent amount of time until retirement — 20 years or more — and can afford to be fairly aggressive. Would it make sense to stuff the growth-oriented investments into your tax-deferred retirement account, and leave the duller, steadier funds for your taxable account? How should you balance the need for growth in your taxable account with the desire to avoid taxes?
Basically, how different should your taxable account look from your retirement account?
In terms of reducing taxes, of course, it makes sense to max out tax-deductible retirement vehicles before putting money into your taxable account. Both 401(k)s and traditional IRAs (but not Roth IRAs) allow you tax deductions of up to $10,500 and $2,000, respectively, assuming you meet the income guidelines.
But let's assume you've already done that (congratulations!) and you have money left over to funnel into a taxable account. Now you're looking at constructing an overall portfolio.
It can all get pretty confusing, so it makes sense to step back a minute and think about what you need in your overall portfolio. "The most important thing is what it looks like from a top-down view when you bring it all together — are you properly allocated?" asks Bryan Lee, a certified financial planner and president of Strategic Financial Planning in Dallas. Before you can think about divvying up your investments into different accounts, he points out, you'll need to think about the asset allocation that makes sense for you in terms of your financial objectives, time horizon and risk tolerance.
Once you've figured out the appropriate weighting of equities relative to bonds, and growth investments to value, consider the investing variables that you're able to control. "There are only two things I can tell clients that we know for sure each year: the cost of fund investing, and taxes," says Lee. "Anything else, like determining the return, I have no idea about. So if we can minimize costs and minimize taxes, then that's going to take care of itself."
For general planning, Lee's approach might serve as a useful starting point. In structuring his clients' portfolios, he starts by looking at the actively managed options available in their 401(k) plans. If the funds look weak, or their expenses run on the high side, he may simply roll all a client's money into the low-cost S&P 500 index fund that's often part of the 401(k) line-up.
Once that's done, Lee diversifies the remainder of the portfolio by cherry-picking investments for a client's taxable account (where he might opt for stocks or exchange-traded funds to reduce tax liability) and IRAs. He makes IRAs the repository for income-generating assets like bonds, or mutual funds or stocks that pay lots of dividends or capital gains.