Transcript:
Hey, guys. Mike Frontera here, back with another retirement theory video. Now listen close. Did you know that you can improve your overall returns without even changing the investments within your portfolio? It's not magic. It's taxes. So much in the same way that hot fudge goes great on ice cream, but terrible on roasted chicken, certain assets work better in certain account types than others. By optimizing these pairings between investments and account types, you can leave yourself with thousands more in after-tax money without even changing the overall composition of your portfolio.
So let’s go through some examples and start to conceptualize this notion of asset allocation. We can see how much of a difference it can make. Don’t forget, if you like these videos, let me know. Be sure to click that like button below, and if you want to see more videos like this, hit that subscribe button too. I think the best way to visualize this is to start looking at these different account types and see why—what characteristics of them match up well to different asset types. For this video, I’m just going to be going over the most major, basic types of accounts. We’re not going to get into more complex account types like trusts, variable insurance contracts, or annuities or anything like that. The purpose of this is to get you thinking in this conceptual way of pairing assets to the correct account type and applying it to your own portfolio.
Okay, so let’s start by looking at the main types of accounts we deal with in retirement portfolios. The first one would be our pretax retirement account—things like traditional IRAs, your 401(k), 403(b), and so forth. Contributions here are generally tax-deductible or made on a pretax basis. They have tax-deferred growth, meaning you don’t pay tax on dividends, interest, and capital gains along the way. So it’s very tax-efficient during the growth phase. It’s actually an extremely tax-efficient wrapper because you pay zero in taxes until you take a withdrawal. So think about it—assets that tend to kick off a lot of interest, dividends, or capital gains pair perfectly with that retirement wrapper because you’re not paying any taxes on that income along the way. Now, of course, when you do withdraw money from these accounts, it’s sort of the worst possible tax treatment. Every single dollar that comes out is fully taxable. For now, I’m not even dealing with the 10% early withdrawal penalty for withdrawals before age 59½. So, conceptually, we can think about assets that are very tax-inefficient while growing—those can all be good candidates.
Let’s talk about the growth itself. Within a typical diversified portfolio, you’re going to have some assets that are very conservative and some that take on more risk and drive some of that long-term growth in the portfolio. If we remember that every single dollar coming out of these accounts is going to be fully taxable when withdrawn, might it make sense to favor the types of assets that don’t have huge growth potential and maybe shift more of our conservative-type assets into these kinds of accounts? So where else might we put some of these higher-growth assets that are also tax-inefficient during the growth phase? Well, we have the Roth IRA next. With the Roth IRA, your contributions come in after-tax, so there’s no deduction for that. But just like that pretax account, the Roth has that tax-deferred growth wrapper, so it’s great for investments that aren’t tax-efficient on their own—ones that kick out dividends, interest, and capital gains. The big differentiator, of course, with the Roth is that all qualified withdrawals are tax-free. That means you can get away with paying zero taxes on all of that growth in that account. So, going back to what types of assets might match up well with this, might we not want to have the most aggressive or high-growth potential assets in the Roth IRA?
Finally, let’s look at regular non-retirement-based investment accounts, typically seen as a brokerage account or perhaps direct with mutual fund families. These are like a Roth insofar as, on the contribution side, you’re not going to get a deduction for it—it all goes in after-tax. This time, though, you do pay taxes on all of your interest and dividends that kick out during the year. In fact, some investments, like mutual funds, will push out capital gains distributions each year, which are taxable to you even if you don’t sell your investments. Whenever you do sell your investments, any growth that hasn’t yet been realized, you’ll owe capital gains tax on upon the sale of that investment. Here’s a little extra wrinkle—those dividends and capital gains are often taxed at tax-preferred capital gains rates, rather than, say, the traditional IRA or pretax retirement accounts, where every dollar coming out is subject to full ordinary income tax rates. Under current law, if you pass away with unrealized capital gains, your heirs can receive a step-up in cost basis, meaning they could sell that investment at that time and have all of those capital gains wiped away and receive that money tax-free. Of course, any current interest is always going to be taxed at ordinary income tax rates every year that it’s earned. Okay, so there’s definitely some complexity in there.
With that, let’s start with a few example investments and, strictly from a tax standpoint, see where they may make the most sense to hold them. By the way, a quick caveat here—asset location, which is what we’re talking about, can make a tremendous difference over time. However, it should not take a backseat to your overall asset allocation strategy and the risk level of your portfolio. In other words, we don’t want the tax tail to wag the portfolio dog. Now let’s look at Jerry. Jerry lives in a hypothetical world, so he follows strict rules that we don’t in the real world, but he helps teach us things, so it’s okay. Jerry’s ordinary income tax rate is 24%, and his rate on qualified dividends and long-term capital gains is 15%. Jerry has a portfolio with four different investments in it. Remember, we’re in a hypothetical investment world, so these are not actual investments.
He has $100,000 in a corporate bond fund that is paying a 5% yield, and he holds this in his taxable brokerage account. He’s got $100,000 in a dividend-paying stock mutual fund, and we’re going to assume that this fund returns 8% over time, 2% of which comes from dividends. We’re also going to assume that this is an actively traded mutual fund with 100% annual turnover—that means throughout the year, all of the stocks get sold and new stocks are purchased within the fund, and when that happens, any growth is passed along to the shareholders as capital gains. This too is in Jerry’s taxable account. He’s got $100,000 in a tax-free municipal bond fund paying 4% interest for 30 years, and he decides to hold this in his Roth IRA. Finally, Jerry has $100,000 in a tech stock that doesn’t pay any dividends, but he’s hoping for significant growth over time. We’re going to assume that, over time, this grows at 8% and pays $0 in dividends along the way—this is somewhat more typical of a growth-style, either small company or tech stock. Jerry holds this in his traditional IRA.
Okay, so let’s fast-forward 20 years. Jerry’s corporate bond interest is fully taxable, leaving him less money to reinvest in the same fund each year, so after 20 years, he has $210,837 of net after-tax money there. Jerry’s dividend stock mutual fund kicks out dividends and capital gains on all the annual growth, so after 20 years paying taxes along the way, he has $372,756 there. Now Jerry’s municipal bond pays him 4% interest, which would have been tax-free anyway, but of course, it’s also tax-free because it’s in his Roth IRA—after 20 years, he has $219,112. Finally, that tech stock in Jerry’s IRA has grown to $466,096, but all of that money is taxable at his tax rate of 24%, so his net after-tax total is $354,233. After 20 years, Jerry is left with a net after-tax grand total of $1,156,939—not too shabby, especially considering he’s made about the absolute worst possible decisions for where to put his assets among these different accounts.
Now let’s turn back the clock again—this is something that is absolutely able to be done in a hypothetical world—and we’re going to start over with Jerry and work on his asset allocation strategy. Up first, we have Jerry’s corporate bond fund. Corporate bonds tend to be very conservative investments with somewhat lower expected long-term returns over time versus stocks. These bonds typically pay interest each year, and interest, as we just noted, is taxed as ordinary income each year—very tax-inefficient on its own. So it sounds like it might be helpful to have this interest received inside a tax-deferred wrapper, like a retirement plan, rather than taxed each year. Since the expected returns are relatively low, let’s have them owned in Jerry’s traditional IRA, as there would be less growth to pay tax on in the future.
Great—now how about Jerry’s dividend-paying mutual fund? It seems to have nice growth, but it is terribly tax-inefficient, so let’s give it that tax-deferred wrapper in a retirement account and own it within his Roth IRA. What about Jerry’s municipal bond? Well, of course, this is a very tax-efficient investment because all of its interest comes in tax-free anyway since it’s a municipal bond, so we’re going to have him own that in his taxable brokerage account. Finally, we have Jerry’s tech stock. Since all of the growth in this stock comes from an increase in share price, or what is known as capital appreciation rather than dividends, no taxes are paid until it’s sold because there’s no taxable income being generated. Capital gains are only payable once an investment has been sold. In the case of the mutual fund example, capital gains are being kicked out to Jerry each year because the manager of the mutual fund is indeed selling the underlying stocks each year—that just isn’t the case with this single stock because Jerry can just continue to hold it. Under current law, if Jerry happened to die while holding that appreciated stock, his heirs would receive a step-up in basis, which means all of those capital gains would be wiped away, and the entire growth could conceivably be received tax-free. For this example, we’re going to assume that Jerry pays his capital gains on the stock, but that’s still pretty tax-efficient, so we’re definitely going to put that inside his taxable brokerage account.
Okay, 20 years has once again gone by, so let’s see how Jerry has done with this new asset allocation strategy—remember, same investments. Jerry’s corporate bond fund at 5% grew to $265,330 in his IRA; after paying his 24% tax, he’s left with $201,651. Jerry’s dividend stock mutual fund has grown at 8% within his Roth IRA, leaving him $466,096. Jerry’s municipal bond pays him 4% interest in his brokerage account—he pays no taxes, and in 20 years, he has his $219,112. Finally, that tech stock in Jerry’s brokerage account has grown to $466,096, but he still needs to sell it and pay those capital gains. He gets to do so at favorable 15% capital gains rates, so his net after-tax total is still $411,181. Now, after 20 years, Jerry is left with a new and improved net after-tax grand total portfolio of $1,298,040. That nets him an increase of $141,101 in after-tax money.
Nice job, Jerry! Of course, your rates of return and tax rates will differ from our pal Jerry, but the concept of an asset allocation strategy still holds very true in the real world. So don’t unwittingly leave big chunks of money on the table by failing to execute on a proper asset location strategy. If you have questions for me, let me know. Come visit me at RetirementTheory.com or send me an email at Mike@RetirementTheory.com. Thanks for watching—see you next time.