AskDong

As I do my taxes this year, I thought I would take careful look at all the different taxable asset classes, and different tax advantaged accounts that can hold them. I think it’s a good exercise every year to classify your assets. This means both Asset Allocation and Tax Allocation. Also when you do purchase an investment, consider carefully what your planned holding period is. Personally I like have some cash in all my accounts so I have opportunity to make purchases in any of those accounts. However, in general I’m fully invested because my time horizon is probably longer than I wish it were. I don’t need the cash for anything and if I do, I rather try to save or even borrow rather than sell. I keep cash in my account only by adding savings. Also in my taxable accounts, if I am worried about the market, I rather use put options to cover my risk rather than selling. As I see it for the companies I want to hold and the mutual funds I plan on keeping – there’s no reason for me to incur incremental taxes along the way.

Below is tax comparison of the different account types. I’ve assumed a current marginal tax rate of 35% which holds through in retirement. For the taxable brokerage account, in calculating net return, I’ve made some simplifications. I’ve assumed at the end of the period that everything will be taxed at the capital gains rate.

Below is an example with a low current marginal tax rate.

As you can see the benefits of a Roth IRA are much more significant when you’re in a low tax bracket. The Roth IRA is too good of a deal to pass up when you’re young.

The other fact you’ll notice is the relatively pitiful performance of annuities and non-deductible IRAs. Unless your assets are income generating, i.e. bonds, or plan on churning through your investments at a high clip, both annuities and non-deductible IRAs suffer from the fact that the long term capital gains rate are currently so much lower than the marginal income tax rates for many individuals. When you invest money in a annuity or non-deductible IRA, you’ve often effectively traded lower capital gains rates for higher marginal tax rates. However, the non-deductible IRA does offer a backdoor for high income folk to a Roth IRA via a conversion. And the annuity can make sense for certain individuals for specific tax reasons. However in general unless you have specific reasons to invest in something like an annuity, you’re generally better off putting your money into a taxable account once you’ve run out of tax deferred options.

So given all the tax consequences of all these different type of accounts, what should you be buying in each account? That’s the topic of discussion for the next post. So stay tuned.