It may be time to turn your thinking about asset allocation in your retirement portfolio on its head.
An article in the July issue of the Journal of Financial Planning, an academic publication aimed at the financial-adviser community, makes a good case for investors to consider reorganizing their investments among their taxable and retirement accounts.
The take-home message for individual investors from the research is twofold, according to the author, William Reichenstein, a Baylor University finance professor.
First, investors should choose their mix of stocks and bonds using after-tax dollars to obtain a more precise measure of risk and return, Reichenstein said.
Second, they should generally house their bonds in retirement accounts and stocks in taxable accounts, despite earlier research suggesting the opposite approach.
"I actually wrote some of those" studies several years ago, Reichenstein said in an interview. "The message was to tax-defer the higher-returning asset."
The working theory was that stuffing high-turnover stock funds into a retirement account would alleviate the expense and hassle of paying capital gains each year on those funds.
But with today's top long-term capital gains tax rate at 15 percent, and if you consider the risk profile of stocks versus bonds, it begins to make sense to hold stocks in taxable accounts, Reichenstein said.
Investors have the choice of putting stocks or bonds in their taxable accounts. If they put stocks in those accounts, they are essentially allowing the government to "own" 15 percent of the risk and return on that money (reflecting the top capital gains rate), he said. With bonds in the same account, the government owns 25 percent (or whatever ordinary income bracket the investor occupies).
But the stock location decision shouldn't override your original asset allocation, or the optimal mix of stocks versus bonds in your portfolio.
And that's where it gets messy when trying to implement the strategy in a real-world situation.
Younger investors saving for retirement, for example, often have much more money in their retirement accounts than in taxable accounts earmarked for the long term. What to do?
Say you want an overall mix of 70 percent stocks and 30 percent bonds. Place the 30 percent bond position in your retirement account, then fill up the remainder of the retirement account with stocks, Reichenstein said. And if you want to choose especially high-turnover, actively traded stock funds, put those in the retirement account next.
Then use your taxable account for more passively managed stock funds, which generate smaller tax bills because of lower turnover.
One exception: If you want to keep an emergency reserve fund in a liquid, taxable account invested in bonds, you'll need to do that separately.
Reichenstein also argues for calculating your asset allocation using a more precise measure of after-tax values.
He uses the example of a worker with $1,500 in bonds in a Roth IRA and $2,000 in stocks in a 401(k) plan, for an apparent allocation of 43 percent bonds and 57 percent stocks.
However, factoring the money on an after-tax basis (he assumes a 25 percent bracket before and after retirement) reveals the worker actually has a 50-50 stock/bond split.
Considering how difficult it is to get many people to save for retirement, this may seem like so much minutiae.
But financial planner Cheryl R. Holland of Abacus Planning Group Inc. of Columbia, S.C., said the fine points of tax planning in a retirement portfolio do matter to her clients, and saving demonstrable amounts of money on taxes is one way she proves her worth to them.
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