You and your spouse have a nice little nest egg of stock and bond mutual funds. A portion of your portfolio is in a tax-deferred retirement account, and the rest is in a taxable account. Should the bond or the stock funds get the tax shelter?
Conventional wisdom says that bond funds should be put in the tax-deferred account and stock funds in the taxable account. The reason: Bond funds generate more current income than stock funds, so therefore they belong in tax-sheltered accounts--since they could otherwise be taxed at ordinary income rates up to 39.6%. Stock funds, on the other hand, realize most of their return in capital gains, which are typically less than the current income of bond funds and taxed by Uncle Sam at a more favorable 28% rate.
CONVINCING CASE. But don't give into traditional thinking so fast. A new study has come to a different conclusion. T. Rowe Price Associates and Morningstar, the mutual-fund research firm, analyzed the returns from stock and bond funds over the past 20 years and found that long-term investors end up with more money after taxes if they put equity funds in a tax-sheltered account and bond funds in a taxable account. "It's better to hold higher-returning assets in a tax-deferred account," advises Sam Beardsley, the T. Rowe Price tax expert who conducted the study.
Indeed, Beardsley's strategy appears to make sense for most people, regardless of their tax bracket, as long as stocks continue to outperform bonds by at least three percentage points and the investor has an investment horizon of more than 10 years. The strategy also works for all types of equity funds except index funds, which don't need to be tax-sheltered: They have little turnover and therefore pay out very little in capital gains.
A look at the study's hard numbers makes a convincing case. Say, for instance, you invested $20,000, divided evenly between a stock and a bond fund, on Mar. 31, 1976, and then liquidated the account 20 years later. If you went with conventional wisdom and put a bond fund in the tax-sheltered account and a growth fund in the taxable account, your total aftertax return would be $128,800. The unconventional strategy would be to shelter your growth fund and put your bond fund in the taxable account. In this case, the total aftertax return would be $142,400--a $13,600 gain in your favor.
What's happening is that investors typically underestimate the impact of reinvesting equity-fund distributions on a tax-deferred basis. The tax-sheltered compounding of the higher-returning stock funds earns more than the compounding of the income thrown off by the bond funds. That's true even though the income and capital appreciation of the stock fund will eventually be taxed at income tax rates, up to 39.6%, when the money is withdrawn, rather than at the 28% capital-gains rate.
Tax-sheltering your income saves you a lot of money over the long haul. For a period of less than 10 years, the difference in returns between a tax-deferred account and a taxable account is not particularly significant. But the difference between the two strategies after 20 years or longer is most certainly worthwhile (chart). After 20 years, for instance, the value of $10,000 in a tax-deferred account grew to $103,574, compared with just $82,681 in a taxable account, assuming a 31% ordinary income tax rate. "This shows the power of tax-deferral over time," says Eleanor Blayney, a financial adviser at Sullivan, Bruyette, Speros & Blayney in McLean, Va.
TOP BRACKET. But if the stock market doesn't outperform the bond market by a substantial margin, then the unconventional strategy doesn't work. As long as stocks return more than bonds over the long term by more than three percentage points, then it makes sense for people at top tax rates to shelter the bigger return. Historically, the spread in returns between stocks and bonds has been about five percentage points: The 20-year compounded annual returns were 14.3% for the Standard & Poor's 500-stock index and 9.7% for the U.S. long-term government bond with a 20-year maturity, according to Ibbotson Associates.
Still, there are a few instances when investors may not want to follow the study's advice. For instance, when the spread in returns of stocks over bonds was three percentage points or less, then the study worked for only those investors who were in the 28% or 31% tax bracket at retirement. That's because the narrow spread in returns between stocks and bonds was not high enough to offset the effect of the higher taxes. Also, if an investor had a short-term time horizon and was in the 36% tax bracket or above, the strategy is not recommended. "It takes time for the advantages of tax-deferred compounding to outweigh the disadvantage of taxing capital gains at higher income tax rates," says Steve Norwitz, a vice-president at T. Rowe Price. Any huge cut in the capital-gains tax rate would also make this approach impractical.
HUSBAND AND WIFE. This strategy isn't necessary for index funds, either. That's because index funds have minimal turnover, and therefore they pay out very little, year in and year out, in capital gains. Says Beardsley: "The overall benefit of putting an index fund in a tax-deferred account is less than with other types of equity funds."
Your personal situation may also dictate that you not follow the course. Say, for example, a husband has all his wealth in retirement assets in a tax-deferred account. His wife's assets are in investment income and an inheritance, mostly in a taxable account. Following Beardsley's study would mean that the husband would invest all his tax-sheltered assets in equities while the wife would invest everything in bond funds. That's not wise, however, in the case of divorce, say. "It's inequitable for one person to have all growth investments and the other to have all fixed income," according to Blayney. She recommends instead that both accounts should be allocating in a similar manner--that is, holding 60% in stock funds and 40% in bond funds, say, regardless of the tax-strategy issues.
While it's best to put stock mutual funds in retirement accounts, what about individual stocks? Jonathan Pond, editor of the Financial Planning Information newsletter, recommends they be put in taxable accounts. "If you have badly performing stocks, the capital loss realized is much more tax-advantageous in a taxable account than a retirement account, because you can offset any capital gains with capital losses," he says.
IN PERSPECTIVE. Say that you had $7,000 in capital gains and $11,000 in capital losses. You can use the $7,000 in gains to offset the losses, ending up with no capital gains. Then, take the next $3,000 to reduce other income, such as your salary, and carry forward the remaining $1,000 into the next year. In an equity mutual fund, the manager, not you, controls when you take capital gains and losses. But with individual stocks, you decide when it's most advantageous to sell. Bottom line: If you have $10,000 in an equity fund and $10,000 in individual stocks, stick the mutual fund in your retirement account.
While tax strategy is important, it's necessary to put it in perspective. When building a mutual-fund portfolio, you first need to decide your risk tolerance and asset allocation. Only after you've sorted that out should you consider the tax picture. For instance, investors who are extremely risk-adverse shouldn't put a significant amount of money in equities just to reap tax advantages. The Beardsley study may have universal appeal. But in the end, investors must tailor the advice to their own portfolios.