Asset Allocation to Lower Your Taxes

How you choose to allocate your investments is critically important for tax planning, particularly if you have high state income taxes.  To maximize returns, you want to have as much of your money untaxed as possible as it compounds and grows.  Having a 10-30% tax bite each year will seriously damage your returns.

Luckily, capital gains are not taxed until the gain is realized – in other words, until the shares are sold and you make a profit.  This means that your shares of a young company that reinvests all of its profits instead of paying a dividend will not result in any taxes until you sell the shares.  Your blue-chip stock that pays a 5% dividend each year, however, will cause a tax bill each year even if you have the shares on dividend reinvestment.

To minimize your yearly taxes and thereby maximize your returns, you want to keep mostly stocks that have low yields in taxable accounts and everything else in tax deferred accounts (like a traditional IRA or a 401K) or tax-free accounts (like a Roth IRA or Roth 401K).  Note that educational IRAs are also tax-free when used for college expenses.  Assets should therefore be allocated as follows, in general:

Taxable Accounts

  • Growth stocks
  • Growth stock mutual funds
  • Tax exempt bonds (e.g., municipal bonds)

Tax Deferred Accounts

  • Bonds
  • High yield stocks (utilities, banks, drug companies)
  • Commodities
  • Income-producing mutual funds
  • Mutual funds with high turn-over ratios

In some cases it may make sense to keep low yield assets a tax-free account such as a Roth IRA.  For example, if you are holding growth stocks long-term, you may have a few stocks that grow dramatically over a period of several years.  If these stocks are in a taxable account, there will be a big tax bill when you sell shares.  If they are in a Roth IRA, however, no taxes will be owed.

This is a judgement call, since not all long-term holdings will work out.  If you have a losses in a tax-free account, you will also not be able to deduct them to offset gains in a taxable account.  Perhaps the best strategy is to keep part of each position in each account.  If things work out, sell the shares in the taxable account first when the position begins to become large, perhaps offsetting the gain with losses in other positions.  Then, allow the position in the tax-free account to continue to grow.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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