We tag certain pools of money for certain purposes. We have emergency funds, opportunity funds, new car funds, etc.
Similarly, most of us tend to see retirement accounts and taxable accounts as separate entities. We think of retirement accounts as intended for long-term goals and taxable accounts as intended (at least partially) for short-term goals.
The natural result, then, is that most of us invest our taxable accounts conservatively and our tax-sheltered accounts more aggressively.
From a purely mathematical standpoint, however, there’s no benefit to doing so. In fact, most of us could earn greater after-tax returns if we flipped our asset location so that it would be closer to:
- Taxable accounts holding your equity investments (preferably ETFs due to their tax efficiency).
- Tax-sheltered accounts holding your fixed income investments.
But very few people do that.
It’s All One Portfolio
The trick is to learn to look at your entire portfolio as a whole.
For example, let’s imagine that you have $100,000 in a taxable account and $70,000 in a Roth IRA. Also your ideal allocation is to have $20,000 in cash (ready to go for emergencies) and then split the rest so that it’s 2/3 in stocks and 1/3 in bonds.
My suggestion would be to invest as follows:
- Taxable account: $100,000 in stock ETFs
- Roth IRA: $20,000 in something very liquid (money market, for instance) and $50,000 in bond index funds.
The problem most people would have with this allocation is that it appears dangerous: What if you need to tap the emergency fund?
- If you pull money (aside from original contributions) out of a Roth, you’ll have to pay the extra 10% tax on early withdrawals, and
- The stock ETFs in your taxable account make a poor emergency fund because they’re so volatile.
In reality, however, you still have an accessible emergency fund. You just have to be slightly more creative to get to it. For example, let’s imagine that at some point, you need to access $10,000, but the market has just had a severe decline, so you don’t want to liquidate your stock holdings. My approach would be to:
- Sell $10,000-worth of stock ETFs in your taxable account.
- Move $10,000 in your Roth from the money market into stock index funds.
By doing so, you’ve accessed $10,000 in cash and your total stock allocation is untouched (meaning you haven’t had to “sell low”).
In Short
By remembering to look at your portfolio as a whole, you can take better advantage of the tax shelter provided by retirement accounts. End result: You earn a greater after-tax return using the exact same asset allocation you already have.