8/1/2020
It matters where you put a new holding when you have the choice between retirement accounts and taxable accounts.
Many investors have retirement accounts and taxable accounts, so which account is right to hold their next investment? Below are some guidelines to maximize the after-tax returns of a portfolio by properly sorting holdings by account type.
There are many types of investment accounts. In an effort not to confuse, or be too long-winded, I will concentrate on the three most popular types of accounts: Taxable (including Individual, TOD, Joint Tenant and Tenants in Common); Traditional retirement plans (401(k), IRA, Rollover IRA, SEP, PSP and SIMPLE); and Roth plans (Roth IRA and Roth 401(k)). I am omitting Trusts because of the many flavors and combinations trusts come in, which are too many just to list.
Taxable Accounts
How they are taxed: Annually, on the net of realized gains or losses. Gains from Long-Term holdings, held for more than one year, have favorable tax rates. Dividends are taxed the same year they are distributed.
Losses in retirement accounts are useless. So, if you are going to sell an investment for a loss, you want it to be in your taxable account. This sounds very straight forward but is harder to plan out than it might seem. If you knew an investment was going to lose money, why would you invest in the first place? And which stocks are the most likely to lose money? A quick heuristic is risk. Risky (volatile) stocks are more likely to be big winners or big losers. Beta is a common volatility gauge that is widely available, no computations needed. If the beta of a stock is above 1, it is considered more volatile, or riskier than the market on average. If you want to own a stock with a beta above 1, which by definition is one half of the market, a taxable account is a good spot for it. If a loss is realized it will offset gains in the same year, carry-over excess losses to future years and reduce taxable income by up to $3,000 a year.
Taxable accounts are unlimited in how much can be contributed or withdrawn from them. This flexibility allows them to be much larger than any contributory account could be. Often, the taxable account is chosen because its where the available cash is. Municipal bonds should be held in taxable accounts because the interest they pay is free of federal taxes (and state taxes if it is issued by the holder’s home state). But one no-no is putting non-qualified dividend payers in a taxable account. These usually take the form of REITs. ‘Non-qualified dividend’ is code for its tax treatment, which is at the shareholder’s marginal rate. I love REITs, more on that in a bit, but they cost too much in taxes in taxable accounts.
Traditional Retirement Plans
How they are taxed: If you are over 59 1/2, any money withdrawn from an account is taxed as ordinary income, with a few exceptions.
In both retirement plan sections the theme will be scarcity. With strict limits on maximum annual contribution sizes, from the IRA at $6,000 a year (under 50 years old) to the most generous I401(k) at $63,500 (over 50 years old), these dollars, and the investments they are put into, should be considered sacred. They are the chosen few who may ride the untaxable golden escalator into retirement land.
In the traditional retirement account, stocks with a beta around one or less, and investment grade bonds (but not municipal bonds), are a good fit. This should include growth stocks but should not include anything considered highly speculative. Dividend payers, nonqualified and qualified, are also a good fit here because they are not taxable. REITs are great for retirement accounts, because they are forced to pay dividends, unlike most equities, where it is optional. However, LPs (companies structured as Limited Partnerships) have a chance to pierce the untaxable bubble if income exceeds certain thresholds. So, to avoid even a chance of bubble piercing, I put LPs in taxable accounts.
Roth Plans
How they are taxed: All contributions to Roth plans are after-tax dollars, they are not taxed again.
Roth dollars should be treated with the maximum reverence that they deserve. They are usually the smallest of the three categories of accounts, but they are forever free of taxes. That lets them skip the golden escalator to retirement land and take the diamond encrusted elevator to the top floor, the sky-is-the-limit floor.
The scarcity of the dollars and the beauty of never being taxed colors the conservatism that should be used. The goal should be low beta stocks, less than 0.75, that pay healthy dividends. A tax-free income stream in retirement is a wonderful thing.
Another approach would argue for high-beta, big payoff stocks in retirement accounts. If you caught the next Microsoft when it was small, and to be tax-free…goes the argument. But wealth is created by building accounts incrementally, not by trying to catch the tail of the next rocket ship. It only takes a few crash and burn lessons to discourage an investor from enthusiastically contributing the max each year; a few more burns by rocket fuel and discouragement turns to dismay, and contributions are canceled. Leaving small, rudderless, retirement accounts that float around until emptied upon passing the age threshold.
Building retirement accounts takes time, and steady progress encourages participation. Annual contributions usually dwarf annual returns in the early years of retirement accounts; but after building for 10 or more years, returns can expect to outpace annual contributions in 100% equity portfolios. Eventually, with consistent contributions and enough time, these accounts can kick off money in retirement, and keep growing at the same time, leading to generational wealth.
Justin Hudock
Starboard Wealth Management
Marstons Mills, Massachusetts
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