Allocating investments to maximize after-tax return.

• Author: Toolson, Richard B.

EXECUTIVE SUMMARY

* In determining the proper division of bonds and equities between taxable and retirement accounts, the investor should seek to maximize after-tax returns.

* In general, assets expected to earn the highest pre-tax return should be placed in a retirement account; this will allow more income to compound tax-free.

* Investors can be classified into at least three types: traders, active investors and passive investors.

How does one decide how much income to invest in a regular, taxable account and how much to put into a retirement account? A number of considerations come to mind, among them projected holding period, tax bracket and desired rate of return. This article examines returns for different allocations, time frames, types of investors and tax brackets.

An investor with a diversified portfolio will normally allocate his core holdings between equities (or equity funds) and bonds (or bond funds) or other fixed-income securities (e.g., money-market funds). An investor with a diversified portfolio invested in both retirement and taxable accounts must decide whether after-tax return is maximized when bonds are placed in taxable accounts and stocks in retirement accounts or vice-versa.

Equities held in a taxable account have an important advantage over bonds. Gains from the sale of equities held for more than one year are taxed at a lower capital gains rate, under Sec. 1(h). In a retirement plan, this tax advantage is lost; all taxable distributions (including gains from sales of equities) are taxed at ordinary income rates. In contrast, bond interest is always taxed at ordinary income rates.

In general, assets expected to earn the highest pre-tax return should be placed in a retirement account; this will allow more income to compound tax-free. Over the long term, equities are expected to earn a higher annual rate of return than bonds; thus, an advantage of placing equities instead of bonds in a retirement account is that more income will be allowed to compound tax-free.

Because there is a trade-off for equities (lower capital gains rates in a taxable account vs. tax-free compounding at a higher pre-tax return in a retirement account), it is not readily apparent whether equities or bonds should be placed in a taxable or a retirement account. This article examines the circumstances under which equities should be placed in retirement accounts and bonds in taxable accounts (and viceversa).

Comparing After-Tax Returns

In determining the proper division of bonds and equities between taxable and retirement accounts, the investor should seek to maximize after-tax returns. Thus, he needs to compare the after-tax returns when bonds are placed in a taxable account and equities in a retirement account (Portfolio 1) with after-tax returns when equities are placed in a taxable account and bonds in a retirement account (Portfolio 2). In this article, these comparisons are made across three groups of investors--traders, active investors and passive investors (terms not defined in the Code).

Definitions

Trader: In Moiler,(1) the Federal Circuit defined a "trader" as one who engages in short-term trading of securities, rather than long-term holding of investments. Return is derived from the sale of securities, rather than from dividends and interest. In Purvis,(2) the Ninth Circuit noted that a trader attempts to catch the swings in daily market movement and thereby profit on a short-term basis. This article assumes that a trader turns over his stock portfolio with sufficient frequency that all stocks are held one year or less; thus, under Secs. 1222(1) and l(h), all capital gains are taxed as ordinary income. If a trader holds equities indirectly through mutual funds, it is assumed that the-mutual fund turns over its portfolio with sufficient frequency that all of its capital gains are taxed to the investor at ordinary income rates.

Active investor: An active investor does not believe that the stock market is efficiently priced; instead, he thinks that, from time to time, stocks may be mispriced.(3) Thus, an active investor occasionally buys and sell securities. This analysis assumes that an active investor occasionally buys and sells stocks or holds mutual funds in which the managers do the same. The active investor holds stock for more than one year to take advantage of long-term capital gains rates. However, stocks are bought and sold with sufficient frequency that little (if any) tax deferral is achieved.

Passive investor: A passive investor is one who believes that securities are efficiently priced and does not try to "beat the market." The passive investor holds securities for a long time, making only small and infrequent changes. This article assumes that for the passive investor, all gains are long-term and capital gains are realized at a 5% annual rate (i.e., the average holding period is 20 years). At this low realization rate, not only does the investor take full advantage of the lower capital gains rates, but also achieves significant tax deferral. A passive investor who invests in equities through mutual funds would typically use index funds or...