Editor's note: A version of this article was initially published on March 2, 2017. It is part of Morningstar's Tax and IRA Guide special report.
You've run the numbers and determined whether your savings rate is on track or, if you're already retired, whether your spending rate is in the right ballpark. You've consulted reliable sources and come up with a logical stock/bond/cash mix given your particular situation. You've culled your retirement holdings down to a lean, high-conviction group.
Next up: asset location--identifying the right account type for each asset type. True, proper asset location won't make or break your retirement plan in the way that your savings/spending rate and your asset allocation will. But if you put some thought into which account types you're using to house which securities, you can both reduce the drag of taxes on your portfolio's return and also exert a higher level of control over taxable events--both worthy goals.
You may have heard the conventional wisdom on asset location. House investments with high tax costs--such as bonds, whose income is taxed at your ordinary income tax rate--in your tax-sheltered accounts like IRAs and 401(k)s. Meanwhile, if you have assets in a taxable brokerage account, employ securities that generate limited income or capital gains distributions on an ongoing basis.
Unfortunately, asset location isn't cut and dried. For one thing, yields on securities are constantly fluctuating; right now, the yields on bonds and other investments whose income distributions are taxed at ordinary income tax rates are extremely low relative to historical norms and in absolute terms, too. So yes, you avoid a bit of taxes by holding income-producing securities inside of a tax-sheltered account, but the income you receive is so low that the tax savings won't add up to much unless yields improve.
In addition to the changing yield climate, the tax treatment of investments changes over time, so what might be an optimal asset placement today might not be a few years from now. For example, prior to 2003, income from stock dividends was taxed at the ordinary income tax rate, so you'd generally want to hold income-rich stocks in your tax-sheltered accounts. But when dividends began to be taxed at the lower capital gains tax rate--as remains the case today--they were no longer verboten for taxable accounts.
Moreover, practical considerations can sometimes completely contradict advice that makes good tax sense. When we're in accumulation mode, most of us naturally use our retirement accounts (401(k)s and other company retirement plans and IRAs) as a storehouse for our longest-term savings, so it's only logical that we'd be inclined to invest in long-term assets (namely, stocks) there.
Meanwhile, from a practical standpoint, it's logical to want to hold more safe, stable, and liquid assets (namely, bonds and cash) in accounts that we can readily tap without strictures or penalties--our taxable accounts. Yet, as much logical sense as those asset-placement arrangements might seem to make, they precisely contradict what a tax advisor would tell you to do. Because income from bonds and cash is taxed at your ordinary income tax rate, that's a powerful argument for holding bonds in your tax-sheltered accounts while keeping at least some stocks in your taxable account.
So, how should you navigate this confusing landscape? There are no one-size-fits-all solutions, and it's worth revisiting your asset-location framework every few years to make sure your plan syncs up with the current tax rules. Retirees, in particular, may want to keep their tax-sheltered and taxable accounts diversified across asset classes; doing so allows them to be flexible about where they go for cash for living expenses.
Here are some general guidelines.
Hold in Your Tax-Sheltered Accounts: High-Returning Assets With High Tax Costs Because you don't have to pay taxes from year to year on income or capital gains you earn in tax-sheltered accounts like IRAs and 401(k)s, these are good receptacles for higher-returning investments that also have heavy tax consequences. The best example would be junk bonds, junk-bond funds, emerging-markets bond funds, and multisector-bond funds, all of which kick off a high percentage of taxable income. And while it's a stretch to call high-quality bonds and bond funds "high returning" right now, they're also a better fit for tax-sheltered accounts than for taxable because their payouts are taxed at an investor's ordinary income tax rate.
So, generally speaking, to the extent that you hold bonds, you're better off doing so within the confines of a tax-sheltered account. If you need to hold bonds in your taxable accounts for liquidity reasons, a municipal bond or bond fund might offer you a better aftertax yield than a taxable-bond investment. (Income from munis is free of federal and, in some cases, state income taxes.) Looking at tax-equivalent yields can help you decide.
By contrast, stocks and stock funds are generally a better bet for taxable account. That said, not all stocks belong in the taxable bin. Although they enjoy relatively low tax treatment currently, dividend-paying stocks are arguably a better fit for tax-sheltered rather than taxable accounts. The key reason is control. Dividend income, like bond income, isn't discretionary. Whereas stock investors can delay the receipt of capital gains simply by hanging on to the stock, investors in dividend-paying stocks don't have that kind of control; they get a payout whether they like it or not. That makes dividend-payers, regardless of tax treatment, less attractive than non-dividend-payers from a tax standpoint.
Your tax-sheltered accounts are also the right spot for REITs, whose payouts are generally considered nonqualified and taxed at ordinary income tax rates. Preferred stock, too, is on the bubble, depending on the type of preferred you're dealing with, and therefore is apt to be a better fit within the confines of a tax-sheltered account. Traditional preferreds generally qualify for dividend tax treatment, whereas income from trust preferreds is taxed at an investor's ordinary income tax rate. Dividends from some foreign stocks and funds may also be classed as nonqualified, meaning they will be taxed as income, but foreign-tax issues complicate the decision about where to hold foreign stocks. (MLPs are an unusual income-rich security in that they're usually best held outside of an IRA.)
Finally, to the extent that you hold mutual funds that churn through their portfolios frequently, you're better off doing so within your company retirement plan or IRA. Such funds tend to generate a lot of short-term capital gains, which are also taxed as ordinary income.
Hold in Your Taxable Accounts: Higher-Returning Assets With Low Tax Costs The above exceptions notwithstanding, there are compelling reasons to hold stocks in your taxable rather than tax-sheltered accounts.
As I noted earlier, long-term capital gains, which are what you have when you sell a stock that you've held for at least a year, are taxed at a much lower rate than is bond income--currently 0%, 10%, or 15% depending on the level of taxable income.
Another key reason to hold stock in your taxable accounts is that stock investors can exert a higher level of control over the receipt of capital gains than bond investors--for example, by buying and holding individual stocks or by investing in equity exchange-traded funds, which have a built-in mechanism for limiting taxable capital gains payouts. Tax-managed funds and traditional broad-market stock index funds also tend to do a good job of keeping the lid on distributing capital gains.
Hold in Either Account Type: Lower-Returning Assets With High Tax Costs So, the key rules of thumb are that stocks go in taxable accounts and bonds go in tax-sheltered wrappers. But what about lowly old cash? From a pure tax standpoint, holding the assets in a tax-sheltered account makes the most sense, as income from cash investments is taxable as ordinary income, just like bond income.
Here's a case, however, where practical considerations may override the tax argument. One of the key benefits of cash is easy access to your money when you need it, so it simply may not make sense to store cash for near-term income needs in tax-sheltered accounts, where you may face taxes and other penalties to pull it out prematurely. And because you're receiving a minuscule income stream from most cash investments these days (you might be holding them for stability as much as real income), the tax hit associated with holding cash in a taxable account is apt to be quite low for most investors.
The bottom line is that if you're holding cash for near-term income needs or as an emergency fund, it makes sense to hold it in a taxable account. If you're holding a sleeve of cash as a component of your retirement portfolio's long-term strategic asset-allocation plan, it's fine to hold it within the context of your tax-sheltered account.
For Retirees, Flexibility Is Key Finally, it's worth noting that the right asset-location prescription depends on life stage. Whereas an accumulator might dogmatically hold stocks in her taxable brokerage account and bonds in her tax-sheltered accounts, retirees would do well to stay diversified within each of their accounts: taxable brokerage accounts, IRAs, and company retirement plans. Maintaining intra-account diversification enables retired investors to pull withdrawals from the accounts that will keep them in the lowest tax bracket in a given year; by holding stocks, bonds, and cash within each account type, the retiree won't have to tap an asset class when it's in the dumps.