Archives for August 2009

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:

1. Taxable accounts holding your equity investments (preferably ETFs due to their tax efficiency).
2. 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:

1. Sell $10,000-worth of stock ETFs in your taxable account.
2. 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.

Readers often email me to ask what to do when you have asset that you’d like to sell, but which has a large unrealized capital gain. The two most common examples being:

1. Shares of a given stock which now make up far too high a percentage of their overall net worth, or
2. An actively managed mutual fund with unreasonably high costs.

Generally, my suggestion is as follows:

First, calculate precisely how much you would owe if you were to sell the asset. If we assume you’ve held the asset for greater than one year, the Long-Term Capital Gain would be taxed at a rate of 15% (unless you’re in a tax bracket of 15% or lower, in which case LTCGs are taxed at a rate of 5%).

Next, weigh the cost of that taxation against the benefits of having an appropriately-balanced portfolio.

Holding Too Much of One Stock

For example, let’s say you own shares of a stock and (in total) they’re currently valued at $100,000. You purchased them (all at the same time, at the same price) for $30,000.

If you were to sell all of your shares, you’d be realizing a LTCG of $70,000. Assuming you’re in the 25% (or greater) tax bracket, the gain will be taxed at a rate of 15%, meaning you’d be paying $10,500 in tax.

Is that too high a price to pay for diversification? If this $100,000 makes up a significant portion of your net worth, it may be wise to accept that 10.5% decline in value now rather than expose yourself to the much larger potential losses that can come from having so much money invested in one company.

It’s also important to note that, assuming you plan on selling the shares at some point in the future (and assuming they don’t decrease in price), you’re going to be paying this tax eventually.

Selling Actively Managed Funds

Alternatively, let’s imagine that you own an actively managed fund and would like to sell it (having been convinced of the benefits of index funds), but your cost basis is significantly below the current value. (Again, let’s use $30,000 and $100,000.)

Again, if you sell, you incur a cost of 10.5%. Essentially the question comes down to how long it will take for the reduced expenses to recoup the tax paid. Often, it’s a much shorter time than you’d think.

For example, it wouldn’t be unheard of for your total costs to decrease by 2% per year or more:

• 0.75% via a lower published expense ratio
• 0.50% via lower turnover
• 0.75% via increased tax efficiency (which is relevant given that we’re obviously dealing with a taxable account here).

At that rate, it would take barely 5 years before your savings more than outweighed the cost of paying the tax. (And you’d now have a higher cost basis in your holding as well, meaning that when you sell the index fund at a later date, you won’t be paying as much tax as you would had you held the original fund.)

In Summary…

Obviously, this sort of situation is something that must be considered on a case-by-case basis. That said, in my own experience, I find that investors tend to overestimate the cost of selling and underestimate the benefits of having an appropriately constructed portfolio.

One final note: In the above analysis, I assume that you don’t have any investments which a) you’d like to sell, and which b) have unrealized capital losses. If you do have such investments, the solution sometimes becomes a no-brainer: Sell both, use the capital losses to offset the capital gains, and invest the cash as you choose.