Tax-Efficient Saving and Investing

February 2006

A central component of investment advice in recent decades both for individual and institutional investors has focused on asset allocation, and rightly so since it plays a critical role in determining returns. For individual investors, tax management also plays a significant role in maximizing wealth but it typically does not receive the attention it deserves. This Trends and Issues examines four types of tax considerations that can reap benefits to investors: Choice of Savings Vehicle. To the degree possible, individuals should take maximum advantage of tax-favored savings vehicles, including tax-deferred accounts such as 401(k)s, 403(b)s and traditional IRAs, as well as after-tax accounts such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s. All of these accounts essentially allow for tax-exempt growth on their after-tax values. After-Tax Asset Allocation. As noted, most individuals are aware of the importance of asset allocation but they calculate it as though assets in tax-deferred accounts are worth the same amount as those in taxable accounts. As a result, they overstate the allocation to the dominant asset class held in tax-deferred accounts. When calculating their asset allocation, they should convert all assets to after-tax values and then calculate their asset allocation using these after-tax values. For example, assets in tax-deferred accounts should be converted to after-tax funds by multiplying the pretax value by 1 minus the expected tax rate during retirement. Sometimes assets in taxable accounts also need to be converted to after-tax values, but the adjustments generally are not as large. Tax-Efficient Investing (Including the Role of the Stock Management Style). Examples of tax-efficient investing in one’s taxable account include: a) tax-loss harvesting, in which capital losses are realized in order to offset capital gains or ordinary income; and, 2) passive, index-type investing where unrealized gains are allowed to accumulate, thus providing tax deferral and even exemption if assets ultimately receive a step-up in basis or are donated to charity. Asset Location. This concept refers to appropriate location of equities and fixed income. In general, fixed income should be held in retirement accounts such as 403(b)s and Roth IRAs and equities, especially passively-managed stocks, should be held in taxable accounts. The reason for this preference is that, when held in taxable accounts, equities are generally taxed more favorably than fixed income. Equities in taxable accounts can benefit from lower capital gains tax rates, and taxation on gains can be deferred as long as the investor continues to hold the equities. Taxation on gains can even be avoided altogether if the owner holds the equities until death, at which time they receive a step-up in basis. In addition, capital losses can offset capital gains and reduce income.