Question

Your retirement savings includes one tax-exempt account and one taxable account. You would like to follow a passive investment strategy and hold a portfolio that includes two asset classes. The first asset class is non-dividend-paying growth stocks and the second asset class is BBB-rated corporate bonds. Would your tax-deferred and taxable accounts include the same proportions of the two asset classes? Why or why not.

Answer 1

No.

An investor with an asset mix of say, 40% Corporate Bonds and 60% non-dividend-paying growth stocks will achieve the maximum benefit if the tax-deferred account holds 40% and the taxable accounts holds 60% of the total assets. In this case, moving all fixed-income investments into the nontaxable account and all equities into the taxable account will provide the maximum benefit.

Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account. Those same capital gains and dividends, however, would be taxed at the ordinary rate (up to 37%) if withdrawn from a traditional IRA, 401(k), 403(b), or another type of retirement account where taxes are paid on the withdrawal of funds.

Fixed-income investments such as bonds generate a regular cash flow. These interest payments are subject to the same ordinary income tax rates of up to 37%.