Occasionally a client asks why their retirement accounts have so much in bonds or, equivalently, why the return on that account is lower than their taxable account. This question came up again recently so I thought I’d take the opportunity to explain here. This is going to be slightly oversimplified, but only slightly.
Which investments should be in which type of account is known as asset location strategy. There is a comprehensive literature regarding this; I have written about it (here) and spoken on the subject at professional conferences as well.
The strategy likely seems odd because we have internalized (I hope!) the sound advice: if at all possible, “max out your retirement account contributions” and “delay drawing from those accounts as long as possible.” Those two pieces of advice are absolutely correct, but I think people often turn them into the closely related but incorrect, “make your retirement account as large as possible.” (There are cases where that simplification is correct, but they are rare and I’m trying to keep this simple.)
You may have heard the old (and good) adage about taxes and investments: “Don’t let the tax tail wag the investment dog.” I.e., you shouldn’t let taxes drive your investment strategy – though I would argue you should let it influence it somewhat at the margin. You should first determine your asset allocation (your desired portfolio), and then determine the optimal location for the investments in that portfolio. To keep this simple, consider someone who has just two accounts: a traditional IRA and a taxable (i.e., non-retirement) account and they have just two investments: a stock index fund and a bond index fund.
To the extent possible the stock fund should be in the taxable account and the bond fund in the IRA. Since the accounts are unlikely to be exactly the same size as the allocations to each investment there will be inevitable mismatches. For example, if the IRA and the taxable accounts are equal size, but the asset allocation is 60% stocks and 40% bonds, then the taxable account will be all stocks, while the IRA will be 20% stocks and 80% bonds. Of course, the overflow could run the other way particularly for wealthier clients who tend to have relatively larger taxable accounts.
Again, we want to do the asset allocation first and then decide which account will hold the investments.
But why do we want the bonds in the retirement accounts and stocks in the taxable account? A few reasons:
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- There is a difference in the income taxation of the yield:
- In the taxable account, each year the interest on the bonds would be taxed at ordinary income rates (higher) while the dividends on the stocks would be taxed at qualified dividend rates (lower).
- In the IRA, the dividends and interest will not be taxed until they are withdrawn from the account and then those withdrawals will be taxed at ordinary income rates (again, higher).
- There is a difference in the income taxation of the yield:
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- There is a difference in the income taxation of the growth:
- In the taxable account, growth is taxed at capital gains rates (lower) when realized (assuming a holding period longer than a year).
- In the IRA, the growth is taxed at ordinary income rates (higher) when withdrawn.
- There is a difference in the income taxation of the growth:
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- There is a difference in return:
- Stocks have lower yields, higher growth, and higher expected total returns.
- Bonds have higher yields, little to no growth (usually), and lower expected total returns.
- There is a difference in return:
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- There is a difference in control over the taxes:
- In the IRA, at older ages, Required Minimum Distributions (RMDs) must be taken, and those distributions will be taxed at ordinary income rates (higher). These are not optional. The larger the IRA grows, the more will have to be paid in RMDs; keeping the growth lower in the IRA helps keep RMDs lower in retirement.
- In the taxable account, whether taxes are recognized or not is determined by whether you choose to sell something – and you can choose to sell things that have gone up less over things that have gone up more (keeping mind that we still don’t want the tax tail to wag the investment dog).
- There is a difference in control over the taxes:
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- There is a difference in taxation to heirs:
- The IRA is considered IRD (Income in Respect of a Decedent) and is taxed at ordinary income rates (higher) to heirs upon withdrawal (and those withdrawals are required to be much faster now than in the past due to provisions in the 2019 Secure Act).
- In the taxable account (under current tax law), basis is “stepped-up” (i.e., any unrealized appreciation is eliminated) so the assets will pass income-tax-free to heirs at the date of death value (changes in value after death are still taxable however).
- There is a difference in taxation to heirs:
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- There is a free volatility option. It is always possible that investments will decline before (hopefully) rising. In a taxable account, this decline can be captured (it’s called tax-loss harvesting) and used against other gains or to offset some other ordinary income (up to $3,000/year). The unused losses are carried forward until they are used in the future. This option is more valuable (more likely to arise) on more volatile investments and stocks are more volatile than bonds. So, we want to keep the more volatile investment (stocks) in the taxable account.
In other words, if you have stocks in the taxable account, their lower yields will be taxed at lower rates and they will likely grow faster and that growth will also be taxed at lower rates (or not at all, if left to heirs). If stocks are in the IRA and the growth drives up the value significantly, the RMDs will be larger, causing a larger income-tax bill, and potentially increasing the dreaded IRMAA surcharge as well.
To recap, you should almost always:
- Maximize your retirement plan contributions.
- Delay withdrawing from your retirement plans as long as possible.
- Invest those plans in the investments in your portfolio with the highest tax rate and the lowest expected growth.
(In the above, I haven’t talked about Roth accounts; see Ruminations on Roth vs. Traditional IRAs for that discussion. I also haven’t talked about charitable strategies which may help with RMDs or rebalancing a taxable account; see Charitable Giving for more on that. Finally, the discussion above overlaps somewhat with our blog post on Tax-Efficient Spending from a Portfolio and Asset Location Strategy. Finally, if the stock investments have high turnover and high return this may change the optimal location. Here I have been assuming index funds which are very tax efficient.)