2. Asset Allocation
Where to put your portfolio has important tax ramifications. The general rule is that tax-efficient vehicles belong in taxable accounts, while tax-inefficient vehicles belong in tax-deferred accounts, such as 401(k)s and IRAs.
There are several reasons to locate some stocks in taxable accounts. First, capital gains can be deferred indefinitely - by avoiding turnover - and possibly eliminated altogether, passing them on to your heirs with a step-up in basis. And dividends are taxed at 15% for most; even for those in the 39.6% marginal tax bracket, they still carry a 20% rate - lower than ordinary income.
By contrast, holding stocks or stock funds in tax-deferred accounts has three distinct disadvantages:
- It converts long-term gains into ordinary income, which may increase the tax burden for some investors.
- Because stocks tend to be faster-growing assets, they create more ordinary income later, when the required minimum distributions will be larger.
- It could cause heirs to miss out on the step-up in basis.
What about Roth Accounts
Although this is a complex subject (and very dependent upon individual situations), a general rule of thumb is that stocks and stock funds should be held in Roth accounts only when there is no more room (from an asset location perspective) in your taxable account. REITs are often properly located in Roth accounts.
Taxable accounts should hold:
- Broad stock index funds
- Low turnover stock funds
- Tax-managed funds
- Individual stocks
Tax-deferred accounts should hold:
- Taxable bonds
- High turnover stock funds
- Gambling stock trading accounts
In part III, we will discuss tax loss harvesting.