 Planning
tax efficiency in investing
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 Dear
Dr. Don,
I had a question on asset allocation. My present age is around 30,
I maxed out my retirement investing through 401(k)s and Roth IRAs.
The remainder of my savings is invested in a taxable mutual fund
account. Given my age, almost all retirement funds are in equities
since these funds can bear the risk of stock-market volatility over
30 years.
The taxable funds have a more balanced asset allocation
of 80:20, equity/bonds, since the timeline of this investment is
about five years. Most of the bond funds are TIPS and Massachusetts
municipal bonds. Almost all asset allocation articles recommend
moving such types of investment into a tax-free or tax-delayed account.
How does a young investor balance taxable investments in a tax efficient
manner?
-- Boston Beanie
 Dear
Beanie,
Tax efficiency is an important part of investing and not just in
taxable accounts. Keeping in mind how distributions out of tax-advantaged
accounts will be taxed is also an important part of investing. The
pretax dollars that you invested in your 401(k) plan(s) will be
taxed as ordinary income when they are withdrawn from the account
as qualified distributions.
Treasury Inflation Protected Securities, or TIPS,
are usually recommended for tax-advantaged accounts because the
inflation adjustments are treated as taxable income each year, but
you don't receive that income until you sell the security. While
you can look at holding TIPS in a taxable account as a method of
forced savings by paying the taxes now so you don't have to pay
the taxes at redemption, investors tend to chafe at this pay-as-you-go
approach.
TIPS held in mutual funds have this same tax issue. Municipal bonds
or municipal bond funds don't belong in a tax advantaged account
because the tax advantage is inherent in the investment. Although
they're not widely available, corporations and municipalities will
occasionally offer inflation-indexed securities.
With long-term capital gains and dividend income currently
taxed at 15 percent less if you're in the lower marginal tax brackets,
there are a lot of ways to manage your tax exposure in a taxable
account. Mutual funds don't give you that flexibility because they
have to pass through their gains and losses to investors. The tax
efficiency of the mutual fund depends on the mutual fund manager's
investment decisions and the investment policy of the fund. Actively
managed mutual funds will be less tax-efficient than most index
funds. Morningstar,
among others, provides tax efficiency ratings for mutual funds.
Depending on how you invest, exchange-traded funds
could provide greater efficiency at lower cost than equity mutual
funds in managing your tax exposure between now and retirement.
The Bankrate feature, "Exchange-traded
funds may help you sleep at night," has more on using ETFs.
If you truly have a five-year horizon on the investments
in your taxable accounts, then I would say that your 80/20 split
between stocks and bonds is a bit aggressive. You can get over 4
percent in cash, and short-term doesn't look all that good for bond
prices. You didn't mention what portion of your portfolio was invested
overseas, but that should be a consideration in your asset allocation
as well.
You've got enough going on in your investments that
it would be worth your while to meet with a financial planner and
talk through some of these issues. I'd recommend a fee-only planner
to provide a consult on these issues. It will be money well-spent.
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