On Investments

Use tax management with retirement accounts

Not all investments belong in a 401(k)

Mar 28, 2018 @ 10:55 am

By John Waggoner

As we approach tax deadline day on April 17, your clients may have a number of questions for you. Some are easy. "Can I deduct the cost of 12 boxes of Girl Scout cookies I bought?" (No.) "Will you back my claim for 14 dependents?" (No).

But here's one you should think about before answering: "Why are most of my stocks in tax-deferred accounts?" Because you should be advising your clients to stuff their retirement accounts with bonds — and gold, if they own any — and keep most of their stock holdings in taxable accounts.

Most advisers know that stocks are long-term investments and that retirement accounts are good long-term vehicles because they are tax-deferred.

"Advisers often jump to the conclusion that most, if not all, of deductible retirement accounts should be in equities," said Gary Schatsky, founder of ObjectiveAdvice.com. "For most people that's wrong, and this is where adding tax efficiency to portfolio management adds value."

Bonds are an important part of any portfolio, and most advisers would agree that having taxable bonds outside a retirement account is a terrible idea. Interest from bonds and dividends from bond mutual funds and exchange-traded funds are fully taxable at a client's maximum tax rate — which could be as high as 37% in 2018.

The exception is municipal bonds. An AA-rated 20-year muni now yields 3.15%, which is the equivalent of a taxable bond yielding 5% for someone in the 37% tax bracket.

But stuffing a retirement plan with stocks is an equally terrible idea. Long-term capital gains on stocks are taxed at a maximum 20% — and that's for single taxpayers with more than $426,7000 in taxable income. Most taxpayers will pay 15% on long-term gains, and a few low-income taxpayers will have a long-term capital gains rate of zero. If a client's stocks are in a retirement account, withdrawals will be taxed at the higher ordinary income rate.

The joy of having stocks in a taxable account are manifold.

• You can use capital losses to reduce or eliminate your gains. Capital losses can offset an unlimited amount of capital gains. If you have fewer gains than losses, you can deduct another $3,000 of losses. Any losses beyond that can be carried forward into the next tax year. You can't write off losses in a tax-sheltered account, Mr. Schatsky said.

• You can donate appreciated stock holdings to charity, allowing you to take a deduction for the current market value of the stock and to bypass any taxes on the gains.

• You can pass appreciated stocks on to your heirs when you die, giving them a step-up in taxable basis and bypassing capital gains taxes. This won't matter to you, since you'll be singing with the choir invisible, but your heirs will appreciate it.

• Qualified stock dividends are also taxed at a lower rate than ordinary income. The maximum rate on qualified dividends is 20%, although the 3.8% tax on net investment income about $200,000 ($250,000 for married filing jointly) remains.

Naturally, there are exceptions. If your clients own stocks that pay nonqualified dividends, such as real estate investment trusts, then they may be better off holding those in a deductible retirement account. (The same is true for mutual funds and ETFs that invest entirely in REITs.)

Depending on your clients' tax brackets, you might also consider keeping gold and physical gold ETFs in an IRA or other deductible retirement account. The Internal Revenue Service considers gold and other precious metals as collectibles, and thereby subject to a 28% tax on long-term gains.

Owning physical gold in an ETF won't soften the blow: Gains on those ETFs are 28%, too. Gains on gold mining ETFs and funds, however, are taxed at the same rate as stocks.

You might also consider holding commodity ETFs in an individual retirement account, at least those that produce their gains by investing in commodity futures. The IRS considers that 60% of your gains are long-term and 40% are short-term, which could result in a maximum tax rate of 26.2%. And the tax efficiency of target-date funds will depend on their overall composition.

It's wise to include stocks in a Roth IRA, however. While you have to pay taxes on your contributions, money comes out entirely tax-free.

"You can be more aggressive in a Roth," Mr. Schatsky said.

Naturally, clients don't live in a perfect world: A tax-deferred account such as a 401(k) plan is the main savings vehicle for many clients.

"You have to take time to ascertain the goals for different parts of a portfolio," Mr. Schatsky said. "You can't manage all parts in the same way. And you have to understand a client's tax and family situation to enhance returns."

(More: 8 essential tax return nuggets for financial advisers)

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