By David Roskoph, MBA, CFP
What Does Tax Have to do with Asset Allocation?
What do you think of when you hear the phrase Asset Allocation? You probably think about the relative percentages of Large Growth vs. Small Value or Domestic vs. International or possibly equities vs. debt (stock vs. bonds). Few independent investors appreciate the virtue of creating a tax allocation of their assets. Since the 1997 Tax Reform Act, the disparity between capital gains and ordinary income tax is potentially double or net 20%. If your income tax bracket is 39%, so too are your short-term capital gains. However, assets held for more than one year qualify for long-term capital gains and are unrelated to your income tax bracket. Long-term capital gains are presently 20%*. For example, if you are furiously day trading stocks, you might well consider a realistic profit potential in light of the tax bite**. Assuming you are in the 39% bracket and you make $10,000 of short-term profits; that’s equivalent to $6,100 of after-tax gains. If, however, you let the $10,000 profit ride through one year you could net $8,000 of after-tax gains! To exemplify the disparity between the two stated tax rates, you would have to make $13,115 profit at the highest short-term rate of 39% bracket and you make $10,000 of short-term profits; that’s equivalent to $6,100 of after-tax gains. If, however, you let the $10,000 profit ride through one year you could net $8000 of after-tax gains! To exemplify the disparity between the two stated tax rates, you would have to make $13,115 profit at the highest short-term rate of 39% just to break even with the $10,000 profit from long-term capital gains rate of 20%. The moral of the story: The higher your marginal rate, the more careful your short-term investment decisions.
Your assets are your assets; even if they are scattered over 8 or 10 separate accounts. Your appetite for risk does not have to be replicated in each separate account as long as the composite picture and timelines make sense. Take a minute to consider the investment allocation versus the tax ramifications in each of your investment accounts. Each separate account probably has several investment allocation options. For instance, your 401K or other qualified plan is likely to offer you several investment alternatives. As well, your variable annuity and variable life insurance plans probably offer similar alternatives. On the non-qualified side, virtually every investment is available. Let’s look at the big picture of a hypothetical investor who has 1/3 invested in index funds, which he intends to let compound until he draws them down in retirement. Our investor likes to play the market with the remaining 2/3 taking advantage of opportunities regardless of their tax consequences. This investor might consider some tax-smart allocation by placing as much of his trading portfolio into his qualified plan and or variable insurance products as possible. There the tax consequences of short of long-term transactions are irrelevant; the funds come out to him as ordinary income when withdraw. For that portion of his investment more or less committed to a long-term horizon (in this case index funds), he should consider shifting them out of his qualified vehicles. By separating the assets into those likely-to-be-traded-within-one-year, the investor maximizes his after-tax gain by minimizing short-term gains (ordinary income) without compromising his desired asset allocation. As your marginal tax bracket rises, it becomes a progressively better deal to pay long-term capital gains over ordinary income tax. Do the math. The difference can be dramatic and well worth the energy it takes to make a composite picture of your portfolio and reallocate among tax-qualified and non-tax-qualified accounts. You might do well to consider a financial planner who can collect the pieces of your scattered investments and create a homogenized, consistent and tax-efficient portfolio which makes sense from a tax and asset allocation perspective.