June 20, 2017
1) Know your investment objectives
Each “pot” of money that you hold should have specific and documented objectives. For instance, you may have an emergency fund that needs to be immediately liquid and accessible, or an employer sponsored 401(k) plan for your expected retirement in 20 years. The investment objectives you have determined for each account will help drive your risk tolerance, and the types of investments that should be considered.
For example, you won’t want to put your emergency fund in high-risk growth stocks since that investment doesn’t meet your need for immediate liquidity and low risk, and you won’t want to put your employer 401(k) account strictly in cash funds yielding 0.1%, since that doesn’t meet your long-term investment growth objectives for retirement.
2) Know the tax status of each investment account
Before you finalize your investments, you need to know how each investment account is taxed. For example, you may have a fully taxable investment account, a traditional IRA that is taxed when distributions are made at ordinary income rates, and a Roth 401(k) plan that is never taxable as long as the withdrawal requirements are met.
3) Understand the types of income generated by your investments
If you invest in a junk bond portfolio, you can expect significant taxable interest income, and possible capital losses if any bonds become uncollectible. For a growth stock portfolio, there will be minimal dividends, but capital gains if the portfolio is successful. With a portfolio of utility stocks, you can expect significant dividend income, and possibly some capital gains.
4) Understand the risk/return profile for the investments
In general, long-term investments with higher risk and higher expected returns are most tax efficient in traditional or Roth retirement accounts, since that structure obtains the maximum long-term benefit for high-income investments. Investments with low risk and low expected returns may be effectively held in taxable accounts, since there will be a lower level of expected taxable earnings.
5) Analyze what happens in worst case scenarios
What happens to your investment situation if we go through another 2008 stock market crash? You need to know what your exposure is from an investment volatility standpoint, and what tax consequences there may be. For example, if you have high-risk investments in newly opened Roth IRAs, you may not be able to effectively deduct losses sustained on those IRAs if the value plummets. However, if you had the same investments in traditional IRAs, you would effectively be able to fully deduct the losses through lower income on your distributions. In a taxable account, you may have flexibility to do some “tax loss harvesting”, where you sell loss investments, and either wait 30 days to avoid the “wash sale rules” that defer the loss, or immediately reinvest in a similar but not identical investment.
Putting It All Together
Based on an evaluation of these five key factors, you should work with your tax and investment advisors to harmonize your tax and investment planning to maximize your after-tax investment returns. There will be some relatively obvious conclusions as part of this planning, for example - tax-deferred insurance products and tax-exempt municipal bonds don’t belong in any retirement plan, your emergency funds belong in a taxable savings or money market account, and your junk bond investments are particularly tax efficient in a retirement account.
Other conclusions are more nuanced and less obvious. For example, a stock fund invested for long-term growth will generate relatively tax-efficient deferred capital gains, so it might be effectively invested in a taxable account or a retirement account, depending on objectives and timelines. Depending on your investment horizon and tax rates, your high-quality/low-yield bond investments may be particularly tax efficient in a retirement account, but they may be fine in a taxable account also. High-risk investments in individual securities may do best in a traditional IRA/401k or a taxable account in case the market values drop and you need to harvest the losses, but if they are sufficiently diversified and invested on a long-term basis, a Roth IRA/401k account may be fine as well.
Given the complexities to this planning, it is imperative that you consult with a tax advisor who understands your investments, and can help you harmonize your tax situation with your investment planning. Making even small tweaks to your investment plan could result in an enormous long-term impact given the magic of compounded returns.
This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation. Please consult your tax advisor for any specifics on these ideas – there are many nuances and issues that have not been fully elaborated in this article.
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