Which of Your Investments Should Be Tax-Deferred?
May 16, 2011
If you are a prodigious saver, you may be making full use of your individual retirement account and your employer's retirement-savings plan, while also stashing money in a taxable account. Your quandary: Which investments should enjoy tax-deferred growth in your retirement account and which should be left in your taxable account, where they suffer the annual wrath of the Internal Revenue Service? Below are some thoughts: Stocks vs. Bonds Should you put stocks in your retirement account and bonds in your taxable account, or vice versa? It is a fiercely debated question. At first blush, bonds seem like the best bet for a retirement account, because they initially kick off more in interest than stocks pay in dividends. What about the capital gains on your stocks? If you hold stocks in a taxable account, you can always delay paying capital-gains taxes by not selling your stocks. Moreover, when you do realize a long-term capital gain, it's taxed at a maximum rate of 28% -- a rate Republicans would like to cut. By contrast, if you keep stocks in a retirement account, all gains get taxed as income when the money is withdrawn and the federal tax rate can be as high as 39.6%. Convinced? I'm not. True, the initial yield on stocks may be less than that on bonds. But the dividends paid by stocks grow over time, while a bond's yield is usually fixed. Meanwhile, folks may plan to buy and hold stocks, thereby delaying the realization of capital gains. Few, however, really do this. ``Even the most conservative managers, who are known for buying and holding, still have 30% annual turnover,'' notes Harriett Zamora, an investment adviser in Coral Gables, Fla. ``People can say they'll buy and hold stocks. But I don't believe them. Our basic strategy is to put the investments with the highest expected total return in the retirement account. There's no question in my mind that you should have stocks in your retirement account and bonds in your taxable account.'' Taxable vs. Tax-Favored Bonds The interest kicked off by Treasury bonds is exempt from state and local taxes, while municipal bonds often go one better, avoiding state, local and federal taxes. But with corporate bonds, Government National Mortgage Association (Ginnie Mae) issues and many other government bonds, there is often no tax break, notes Samara Ballou, a vice president of taxes at Baltimore's T. Rowe Price Associates. Result? If you're going to keep bonds in your taxable account, consider plunking for Treasurys or municipals, so you can take advantage of the tax savings, while putting corporate and Ginnie Mae issues in your retirement account. Growth vs. Value Stocks Many stock-fund managers stick with either growth stocks or value stocks. Growth companies hold out the promise of rapid earnings and revenue growth, and they typically pay little or nothing in dividends. Value stocks, meanwhile, appear cheap based on current earnings and corporate assets, and they tend to boast above-average dividends. Because of that richer dividend, many experts say you should put value funds in your retirement account and, if necessary, leave growth funds in your taxable account. The growth funds, of course, could kick off large capital-gains distributions, on which you then have to pay taxes. But such distributions are unpredictable, whereas income distributions are all too reliable. If a value fund favors stocks that pay high dividends, you can be pretty sure you will get a big income distribution each year. Actively Managed vs. Index Funds Many stock-fund managers trade like crazy, realizing their gains quickly and often making big annual capital-gain distributions. By contrast, index-fund distributions tend to be relatively modest. An index fund buys the stocks in a designated index in an effort to match the index's performance. Because index funds rarely sell stocks, they tend to be fairly tax-efficient. As a result, consider index funds for your taxable account while saving actively managed funds for your retirement account. U.S. vs. Foreign Stocks A case can be made for putting U.S. stocks in your retirement account and foreign stocks in your taxable account. With foreign stocks, whether you own them directly or through a mutual fund, you may lose a slice of your dividends to foreign taxes. But if your foreign stocks are in a taxable account, you can claim a credit for the foreign taxes using IRS Form 1116 or a deduction using Schedule A. You can't claim either a credit or a deduction if your foreign stocks are in a tax-favored account. Taking the deduction is fairly simple. Claiming the credit on Form 1116 -- which should result in the greatest tax savings -- can be a nightmare. ``By the time you pay your accountant, it's probably not worth it,'' Mr. Zamora says. Got a question or complaint about the Getting Going column? Send your e-mail to editors@interactive.VastPress.com. Your comments and queries may appear in the GetGo Exchange, part of The Vast Press Interactive Edition.
