| Investment Strategy and Taxes |
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Investment Strategy and Taxes
The July 2005 issue of Tax Report prompted me to elaborate on the interaction of a tax strategy with an investment strategy. Before embarking on this task, however, let me begin with three items that are commonly known as “the fine print.”
I am an accountant with expertise in the area of taxation—I am not a qualified or even an unqualified investment advisor. Keep this in mind as you read.
Tax law is in a constant state of change, depending on current economic and political fads. What may be valid today may not make too much sense tomorrow.
The article deals with long-term strategies. There is no such thing as a long-term strategy today in corporate America, as corporate executives cater to their own need for short-term performance, and as we investors continue to demand that the current quarter’s performance meet or exceed analysts’ expectations. We do not understand the concept of short-term pain for long-term gain.
But enough of the fine print, and on with the analysis.
Most successful investment advisors use what is called an asset allocation model. Using asset allocation, the advisor first seeks to determine the investor’s short-term and long-term needs and goals, and the investor’s tolerance for risk (what keeps him awake at night) for that stage of the investor’s life. A model is then created that will allocate the investment into different categories, with a percentage being allocated to cash for liquidity, a percentage in fixed income securities, a percentage in tax exempt securities, a percentage in growth equity investments, percentage in income generating equity investments, and so on—hopefully with the percentage totaling 100%. The asset allocation model should change over time as life’s circumstances change.
The advisor then invests his client’s funds to conform to the model. In this process, investments should be diversified across different market sectors to protect the client from major market fluctuations. For example, if one sector, say telecommunications is down, another sector such as pharmaceuticals may be up. Searching for the next “hot stock” is a little like purchasing a lottery ticket. Because of the changes in value over time, the advisor will sell and purchase some investments to rebalance the portfolio so it conforms to the asset allocation model.
Most investors have several “baskets” of funds to invest—after tax funds, Roth IRA funds, 401(k) funds, regular IRA funds to mention a few. Over the years I have noticed that most people treat each basket separately, often being disciplined investors with the taxable funds, and using the retirement funds for speculative investments, because that cannot touch those funds until many years in the future. This, I believe is a mistake, given the differing tax treatment of each type of account and of each type of income.
Taxation of differing types of income
Interest income and pension distributions are taxed as ordinary income, at tax rates that range from 10% to 35%. Gains from investments held more than one year and most dividends are taxed at rates from 5% to 15%. Interest from most municipal bonds is exempt from tax, although some portion may be subject to the alternative minimum tax.
Distributions from 401(k) plans, regular IRA accounts and most pension plans are 100% taxable (keep in mind that amount invested in the account was never taxed). Qualifying distributions from a Roth IRA are exempt from tax (keep in mind that tax was paid on the amount invested in the account), and the income from after tax accounts is subject to tax based on the type on income earned.
An example. Income from municipal bonds is exempt from tax. If a 401(k) plan were to invest in municipal bonds, the income would be taxable as ordinary income when distributed—it would lose its character as municipal bond interest.
In applying the asset allocation model across all available baskets rather than for each basket, it become possible to become more creative. Funds for liquidity should never be held in a regular IRA or a 401(k) account, as the full amount would be taxable if needed. If you are at the stage where withdrawals are possible from a Roth IRA, that is an ideal vehicle for liquid funds—otherwise they should be in the taxable account. Fixed income securities belong in the 401(k) and regular IRA as the income is taxed as ordinary income, whether received as interest in a taxable account, or as pension distributions, or in the Roth IRA where they will be distributed fee of tax. Equity investments generating qualified dividends and long-term capital gains may be best in the taxable account where the relatively low income tax rate can be preserved.
One final consideration in planning. The beauty of qualified retirement plans is that assets can grow free of tax, and therefore can grow faster. It may be worth putting those assets with a potentially low rate of tax into the 401(k) or IRA as the growth may well be worth the higher rate of tax when distributions are made. The only way to know the answer is to “do the numbers.” Keep in mind the fine print at the beginning of this article, and good luck with your crystal ball.