Katherine Powers is no dummy.
The 48-year-old English professor at a major East Coast university fully contributes to her university's 403(b) retirement plan, has an Early Retirement plan (where the university contributes an additional 2.5%), and maintains an IRA rollover account from a previous employer. And that's not all: Outside her retirement plans, she invests in eight mutual funds.
Katherine has made some good investments, yet she, like many of us, wonders if she should be investing differently--both inside and outside her tax-deferred retirement accounts. What types of investments should we put in each to make the most of tax deferral?
The Old and New Approaches
The traditional approach says to hold bonds in a tax-deferred account and stocks in a taxable account. The rationale is that you're better off deferring taxes on securities, such as bonds, that generate a lot of income and are therefore not very tax-efficient.
|Tax-Efficiency of Three Types of Mutual Funds|
|Fund Type||Avg Annual|
Pretax Ret ( % )
Aftertax Ret ( % )
Efficiency ( % )
|Growth and income||15.72||13.03||82.9|
|Data covers the 20-year period ended December 31, 1998.|
A new study by T. Rowe Price that examines which types of funds work best in taxable versus tax-deferred accounts draws a somewhat different conclusion. It says that, in many cases, you should own stocks in tax-deferred accounts and bonds in taxable accounts, especially if you're investing for 15 years or longer.
Why? Because if you're investing long enough, the higher compounded total returns of stocks are more taxing than the income of bonds. T. Rowe Price compared the results of investing $10,000 in three types of mutual funds--growth, growth and income, and taxable bond--for 10-, 15-, and 20-year periods ended December 31, 1998.
Let's look at an example. Investor A and Investor B each decide to place $10,000 in a bond fund and $10,000 in a stock fund. Investor A keeps her bond fund in a taxable account and her stock fund in a tax-deferred account. Investor B does just the opposite, placing the bond fund in the tax-deferred account and the stock fund in the taxable account.
Assuming an ordinary income rate of 28%, a capital-gains rate of 20%, and liquidation of both accounts after 20 years (ended December 31, 1998), Investor A, who put the stock fund in the tax-deferred account, ended up with the best aftertax results--even if that stock fund was a growth-and-income fund. The table below compares the results of the two portfolios, investing in either a growth fund or a growth-and-income fund for the stock portion.
|Total Aftertax Value of Portfolio|
Investor A's Value ( $ )
|Investor B's Value ( $ )|
|Growth and income||171,600||159,500|
This pattern held up for higher tax rates (31% and 36%), too. Only when the time period was less than 10 years did the pattern break down.
Conclusions and Gaps
T. Rowe Price drew a handful of conclusions from its findings:
The study has its gaps, though. For starters, it didn't include a situation where 100% of an investor's portfolio is in stocks. But if you take the study's results to their logical conclusions, the more efficient stock funds should be in taxable accounts, and the less efficient ones should be in tax-deferred accounts. The study also assumes that all assets are distributed at retirement. Many people continue to defer well into retirement, so those results will differ.
The study also didn't address the quality of the fund choices available within the tax-deferred plan. For example, say your plan offers only two choices: a highly rated large-cap index fund or a poorly rated actively managed small-cap fund. If you listened to the study, you'd probably choose the small-cap fund for tax reasons--even though it's not the better investment overall. Don't let taxes considerations overshadow the quality of an investment.
Applying Theory to Katherine's Reality
Katherine has more than 15 years until retirement. She's in the 31% tax bracket and expects to be in the 28% bracket once she retires. So it makes sense for Katherine to place actively managed funds in her tax-deferred accounts and index funds and bonds in her taxable account.
I chose to keep the TIAA annuity where it was in order to better match Katherine's risk tolerance. (The alternative would have been to move it gradually into CREF stock.)
Since Katherine already had a number of investments with TIAA-CREF, I rolled over her IRA to an account where she can purchase a number of actively managed funds from different fund families. I also increased the amounts allocated to some of these funds and added a couple of new funds to better balance the portfolio. In her taxable account, I balanced capital gains and losses for the actively managed funds and invested the proceeds in index funds. Click here to see Katherine's current allocations and my suggested changes.
Read the new T. Rowe Price study and apply it to your own portfolio. By thinking about where your investment choices should be housed, you may end up with more in your pocket after taxes. I won't be giving an exam next week--the real test will be what you do to improve your portfolio.
|Morningstar Rating||Morningstar Analyst Report|