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Where should I put my riskiest holdings, taxable or tax-sheltered portfolio?

Feb 10, 2012 by Vivian from Mesa, AZ in  |  Flag
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11 votes

Good question Vivian and the answer has a lot of depends to it! LOL. It depends on your age, it depends on your goals, it depends what you consider to be a risky investment. For broad based asset classes, historically, small cap value has been the best returning and riskiest asset class. Just as in life, there is no free lunch in the world of investments. If you were to invest in an actively managed small cap value fund it may be wise to do so in a tax sheltered account. Conversely if you were to invest in a tax efficient small cap value index or Exchange Traded Fund a taxable account may be better.

Let's change the conversation a little Vivian, if it's pure tax efficiency is you goal, it may be best to keep you fixed income funds in your tax sheltered account. Interest from bonds is taxed as income which is usually higher than capital gains. Of course if you followed that strategy your taxable accounts would become riskier for lack of fixed income. A solution would be to have your taxable fixed income in municipal bonds.

Comment   |  Flag   |  Feb 10, 2012 from Cleveland, OH

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11 votes

There are a couple points to consider here:

  1. What is the time horizon of these riskier investments? If these risky investments are ones that you intend to buy and hold for a while, it makes more sense to put them in a taxable account and to save your tax-deferred accounts for income-oriented investments that generate taxable current income. Remember, you only pay capital gains taxes when you sell.

  2. How risky is "risky?" If you are talking about doing aggressive trading or a speculative strategy, you don't want to "waste" your IRA or Roth IRA on something that will blow up. Put your "real money" in a retirement account, and your "play money" in on online brokerage account with a discount broker.

Comment   |  Flag   |  Jun 22, 2012 from Dallas, TX

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11 votes

I must respectfully disagree with anyone who says that asset location does not matter. Asset location matters very much, especially over a long time horizon. Moreover, the increase in availability of ROTH accounts since the income limits were lifted for ROTH conversion a couple of years ago, has magnified the importance of asset location.

Kirk Kreikemeier is absolutely correct: highest risk / highest return assets should be put into the ROTH to maximize the economic benefit of tax-free compounding. This benefit is worth more than the benefit of tax-deferred compounding, and is one reason why some advisors (like me) usually recommend that individual investors with long time horizons convert their traditional IRAs to ROTH accounts. After-all, the objective is not to minimize tax, it is to maximize after-tax portfolio value.

Comment   |  Flag   |  Sep 09, 2012 from San Francisco, CA

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7 votes

When choosing where to place an investment, there are a number of items you should consider beyond the riskiness of the asset.

In general there are two types of taxes you'll experience: Ordinary income taxes, which you pay on income producing assets and assets held under one year, and long term capital gains, which is the tax you pay on the price appreciation of an investment that is held for longer than one year. Long term capital gains are taxed at a lower rate than ordinary income. The max federal rate for ordinary income is 39.6% and the max for capital gains is 20%.

So based on that knowledge, as mentioned above, you need to determine whether the asset is income producing or not. Bonds, mortgage REITs (real estate investment trusts), short term trades (holding a stock under 1 year), and dividends from stocks that do not yet qualify for qualified dividend status, will be taxed at normal income rates.

For this reason it may make more sense to buy these types of assets in an IRA or Roth IRA. An IRA would allow you to wait to pay taxes until retirement, while a Roth IRA would allow you to have both tax free growth and distributions.

However, There are some other considerations you need to ponder before you simply place all of the income producing assets in an IRA.

  1. The frequency of trading.

If you are an active trader, consistently holding assets for less than 1 year, it makes more sense to hold those items in an IRA because you don't pay taxes after every trade. So instead of paying an income tax of, let's say 25% of your gains each time you make a trade, you get to keep 100% of your gains and add that you to your base capital. This is the difference between growing your account at 10% before taxes and 7.5% after taxes. Over time, where you trade an active account makes a MASSIVE difference.

If your account is more passive and few trades occur, then you may not have to worry about how much you are being taxed.

  1. The structure of the investment.

There are several types of investment companies that people generally invest in. These include mutual funds, ETFs and master limited partnerships. The government taxes each of them in a different way, making some better than others for an IRA account.

I'd like to highlight one type of investment that can give you some trouble come tax time.

Master Limited Partnerships (MLPs) can be taxed in an entirely different way than mutual funds or ETFs.

MLPs generally invest in "risky" activities such as oil and gas production, commodities trading, or real estate management. Instead of participating in the investment as a shareholder, you are a limited partner in the firm. Income and capital gains from the partnership will be K-1 (partnership) income. While this poses no problems in a taxable account (except more paperwork), this can cause problems by creating a transaction considered Unrelated Business Taxable Income (UBTI).

This type of transaction "breaks" the tax deferred advantage of the IRA and causes the distributions to be taxed at normal income rates and then taxed again at retirement (in a traditional IRA). Sometimes MLPs can be advantageous in an IRA, other times they should be avoided. The full implications and uses for this type investment are beyond the scope of this answer, but I wanted to make you aware of the possible consequences.

  1. The stage of the investor's life.

For this part let's say you have a Roth IRA (where you make taxable contributions and withdraw from the IRA tax free).

Pre-retirement is generally considered the accumulation phase for investors. During this time period it may be advantageous to place the majority of items like stocks and your riskier assets into a Roth account so that you may grow the capital in your Roth account at a higher rate.

However, once you move into your retirement years, you don't have to pay taxes on your Roth Account, so you can buy your income producing assets in that account so that the income can be paid out tax free. If we assume you have only a few trades each year, your stocks can then be placed into a taxable account and then be subjected to the lower capital gains rates when you need to sell them.

These are just a few examples to get you thinking about other dimensions of the investments that go beyond the riskiness of the asset.

Hope this helped.

Comment   |  Flag   |  Feb 23, 2013 from Chester, MD

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6 votes

Yes your primary consideration is the appropriate asset allocation. But once you have that, it is worth picking up additional value by considering asset location. In addition to the comments mentioned, if you have both a Roth and Traditional IRA, put your highest expected return assets in the Roth since any investment gain comes out tax-free where the traditional IRA gains come out and taxed as ordinary income.

Comment   |  Flag   |  Sep 08, 2012 from Western Springs, IL

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6 votes

Riskiest holdings should be held in a taxable account. Riskiest holdings returns usually come from capital appreciation and not dividend and interest income. The capital appreciation from a risky holding can be deferred until sale and in some cases, indefinitely. Riskier investments usually involve a higher probably of loss of capital, and the capital loss could only be used as a write off against your other capital gains or normal income if the loss is incurred in a taxable account. Losses incurred in tax deferred account are not tax deductible.

2 Comments   |  Flag   |  Nov 01, 2012 from Atlanta, GA
Erik Evans, CFP®

This is the best answer. Right on Matthew!

1 like | 
Flag |  Nov 02, 2012 near Berwyn, PA
James P. Dowd, CFA

This approach is
correct when the only two choices are taxable and tax-deferred, turnover is low, and the tax rate on capital assets is low relative to ordinary income rates. However, when there is a ROTH option, the highest return (highest risk) assets belong in the tax-free account, where the compounding effect is greatest.

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Flag |  Nov 02, 2012 near San Francisco, CA

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4 votes
Jonathan Foster Level 16

Hi Vivian,

It has been a pleasure to read the thoughts of my colleagues! Here's my take on the question at hand. First comes "asset allocation", then "asset location." In short, where you house your investments matters little if you make poor investments! The value of a tax shelter is worthless if you have no gains to shelter. First and foremost, make the right allocation between stocks and bonds with regards to your risk tolerance. Ask you advisor for help.

Now, let's assume you are making investments that are sound, and like most investors, you are some type of a "balanced" investor (equities and fixed income). Equities for capital appreciation and fixed income for income and safety of principal.

Contrary to the belief of most investors, you should use your tax-deferred vehicles (IRAs, etc.) to hold your fixed income investments and your taxable accounts to hold your capital appreciation assets. The reasons are quite clear. If you own taxable bonds. you get a higher yield than munis. Therefore, own corporates in your IRA and enjoy the higher yield! The only tax game left in town is the 20% federal tax rate on long term capital gains, so why waste this by owning stocks in your IRA, where when you take the distribution, the gains will be taxed at your highest marginal rate, not the preferential capital gains rate?

Where possible from an asset allocation standpoint, own stocks in your taxable account, and your income securities in your tax-deferred account. Long-term capital gains and qualified dividends are both tax-advantaged.

One caveat...if you have a Roth IRA, own your greatest appreciating assets in the Roth. This is because distributions from your Roth is untaxed.

I hope this helps!

Jon Foster

Comment   |  Flag   |  Feb 21, 2013 from Santa Monica, CA

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3 votes

Frankly I don't think it matters that much. What is most important is your asset allocation: mix of stocks, bonds and cash and your savings rate.

1 Comment   |  Flag   |  Jun 22, 2012 from Port Washington, NY
Erik Evans, CFP®

An asset location approach (also known as the "difference approach") has been shown to provide an average 20-bps-per-year, after-tax return benefit over simply using identical allocations in multiple accounts with different characteristics. This was well documented by Gobind Daryanani, PhD, CFP and Chris Cordaro, CFP in the Journal of Financial Planning, January 2005, "Asset Location: A generic Framework for Maximizing After-Tax Wealth." You can read the full research at: http://www.irebal.com/docs/AssetLocation.pdf.

Flag |  Nov 02, 2012 near Berwyn, PA

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2 votes
Rich Winer Level 20

Vivian, the riskiness of your investments should not determine where those assets are held. There are other, more important, variables that must be considered. Because of the potential tax consequences of making the wrong decision, you should consult with financial advisor who, after learning about your financial situation, goals, objectives, risk tolerance, time horizon, investments and level of expertise can provide you with the best, most appropriate recommendation for your individual circumstances. It would be almost malpractice to provide you definitive advice in this forum... and here's why. As one advisor correctly pointed out, you risky investments might be growth stocks that pay few or no dividends, which might make them appropriate for a taxable account. However, if you are an active trader of these risky growth stocks, then they should be held inside a tax-deferred account where your could trade to your heart's content with no tax consequences (capital gains). In addition, what you consider to be risky, someone else may not feel the same. Some investors believe that all stocks are risky. However, in a rising interest rate environment, bonds (which are adversely affected by rising interest rates) could be considered risky. Some advisors will advise you to put bonds in tax-deferred accounts where others will recommend stocks. Consult, face to face, with a good financial advisor and take it from there. I hope this helps.

Comment   |  Flag   |  Apr 17, 2013 from Woodland Hills, CA

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1 vote

This is a great question and, as you can tell from all the answers, many of us have opinions on it. I would keep it simple: income producing investments go in tax-deferred/sheltered accounts and capital appreciation investments go in taxable accounts. This way you don't increase your taxable income each year with the income producing investments and can choose when to pay capital gains on your growth investments. Hope that makes it simple and easy, Nick

1 Comment   |  Flag   |  Feb 25, 2013 from King of Prussia, PA
Alex Bentley

Great answer! Simple and true.

Flag |  May 29, 2013 near Pacific Palisades, CA

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