Allocating assets between taxable and non-taxable accounts

People have been asking me lately about whether there is any advantage to putting certain types of investments in taxable versus non-taxable accounts. Short answer: yes, there is. Here is a short post on how to think about sorting investments between types of accounts. We'll first discuss the types of accounts, then types of investments, and then conclude with a sample asset allocation.


Types of investment accounts

Most Americans have access to three main types of investment account: regular brokerage accounts, Individual Retirement Accounts (IRAs), and Roth Individual Retirement Accounts (Roth IRAs--they are named such because Senator William Roth first proposed the idea for them). You may have also heard of 401(k) accounts, which are the same thing as IRAs except they are managed by your employer. You can have Roth and non-Roth versions of 401(k)s.

A regular brokerage account is just an account you use to trade stocks and bonds. Any money you put in there comes from your bank account, which comes from your paycheck, typically after you have already paid taxes on it. So if you earned $100, and the government took 30% in tax, the remaining $70 could be transferred into a brokerage account to use for trading. This sounds fine until you realize that any investment income you earn from that $70 is again liable for tax. If you use that $70 to buy a share of Apple, and Apple goes up to $90 and then you sell it, you have to pay some amount of taxes on the $20 of profit. This means you get taxed twice, effectively, on money in a traditional brokerage account.

With an IRA or regular 401(k), you set aside a portion of your paycheck that goes straight into the IRA, before you pay taxes on it. So if you earn $100, you might put $30 directly into the IRA, leaving $70 as taxable income... paying 30% taxes, leaving you with $49 in your bank account. You could then put that $49 into a regular brokerage account, leaving you with $49+$30 = $79 of total investment assets, versus $70 in the example above. You do have to pay takes on IRA money eventually, but that's only when you withdraw them from the account when you retire. Since retirees often pay a lower tax rate (due to lower income) than working people, you benefit again, as instead of paying 30% taxes up front, you get to pay something less than 30% much later. This has two obvious advantages: 1) you potentially pay a lower tax rate and 2) you get your investment to compound for many years before you pay taxes. You can also trade as much as you want in IRAs without triggering capital gains tax, since you only pay tax when you withdraw the money. Regular IRAs are often called tax-deferred accounts.

A Roth is like an IRA, except you pay the taxes up-front, and then never pay taxes again. So with a Roth, you earn $100, pay taxes on it, leaving you with $70. You can then invest that $70 in anything you want, and never pay taxes on the Roth money ever again. Roth IRAs or Roth 401(k)s are often called tax-free accounts.


Types of investments

Taxation is a complicated topic, but I'll attempt to distill the most important concepts here that relate to investment allocation. From a tax perspective, there are three kinds of investments: 1) investments free of tax, 2) investments that get charged a lower rate of tax (capital gains tax), and 3) investments that are taxed at the normal, ordinary income rate.

I'm not a registered financial advisor so let me say that I am not giving financial advice here. I am merely explaining my thought process for how I allocate investments. The overall goals are maximizing returns and minimizing taxes.

Rules of thumb, pre-retirement:

1) All tax-free investments (e.g. municipal bonds) go in regular investment accounts (I don't want to use up valuable IRA/Roth IRA space for these)

2) My highest-yielding (expected return) assets go into Roth IRA money first (since I will never pay tax on these, I want the most potentially lucrative stuff here)

3) Assets that are high-yield and taxed at ordinary income rates like REITs and MLPs also go into Roth money (since ordinary income is taxed at a higher rate, I want to avoid that tax completely if I can)

4) Any of #2 and #3 that I don't have enough Roth money for goes into regular IRA money

5) Things like high-yield bond funds are good candidates for left-over IRA money

6) Buy-and-hold stocks that don't pay dividends are good candidates for regular brokerage accounts, since the year-on-year taxes are avoided because the stocks don't recognize returns until you sell them. One downside to this is you are basically stuck in the stock unless you are willing to eat a capital gains tax.

7) Anything left goes into regular accounts, once IRA and Roth IRA money is used up.


Example: Bob

Bob is a young guy (age 30) who has managed to save up the following: $20,000 in a Roth IRA, $10,000 in an IRA, and $30,000 in cash, which he'll move into a brokerage account. Let's say he decides on the following asset allocation:

I may cook up an example calculator to help you play around with asset allocations in your own accounts.

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