Where Should You Hold Your Equities?

One common investment mistake some investors make has to do with the asset location decision — dividing assets between taxable and tax-advantaged accounts.

The conventional investment wisdom is to locate equities (those expected to have higher returns) in tax-advantaged accounts and bonds in taxable accounts. Thus, many investors hold their equities in tax-advantaged accounts — such as IRAs, Roth IRAs and annuities — and then hold municipal bonds or other fixed-income investments in taxable accounts. However, the current tax structure should encourage investors to consider reversing that strategy.

Only those investors who are very active traders (whose trading activity is so frequent they don’t qualify for the preferential capital gains treatment, thus losing an important advantage of equity investing) might be advised to follow the conventional wisdom. Note that the evidence is compelling that active traders, on average, have underperformed their appropriate benchmarks, even before taxes.
 
There are five reasons one might prefer holding equities in taxable accounts. First, holding equities in tax-deferred accounts converts what would otherwise be long-term capital gains into ordinary income, subjecting the gains to the higher income tax rates. In addition, in most cases, withdrawals from tax-deferred accounts prior to age 59½ are subject to a 10% early withdrawal penalty. And required minimum distributions must begin no later than April 1 of the year after which you turn age 70½. Investors also have the ability to time gains within their taxable accounts to take them in low-tax years (years when their marginal tax rate might be lower) and to potentially take losses in high-tax years.
 
Second, holding equities in taxable accounts creates the potential for a step-up in basis upon death, thus avoiding all income taxes.

Third, holding equities in taxable accounts creates the potential for tax-loss harvesting, which can allow investors to reduce their tax bill.

Fourth, holding equities in taxable accounts allows investors to donate appreciated shares to charities, avoiding taxes altogether.

Fifth, holding international equities in taxable accounts allows an investor to take advantage of the foreign tax credit (FTC). The FTC has no value in tax-advantaged accounts.   
Keep in mind that the location decision is a preference. Investors typically should choose to first fund tax-advantaged accounts. Thus, if you don’t have sufficient room in your taxable account to accommodate all of your equity holdings, you might still want to hold them in a tax-advantaged account.

Another bit of conventional investment wisdom that is typically wrong is that investors who don’t have enough room for their equities in tax-advantaged accounts should own them inside of variable annuities (VAs). For all the reasons that investors should prefer to hold equities in taxable accounts versus tax-advantaged ones, they should also prefer to hold them in taxable accounts and not VAs.

Holding equities in a VA causes the loss of the potential for a step-up in basis for the estate of the investor, the inability to harvest losses, the inability to donate appreciated shares to charity and the loss of the foreign tax credit. And should the buyer need liquidity prior to age 59½, unless the distribution takes the form of a life annuity, an additional 10% penalty would apply.

Besides all that, there is another reason to avoid VAs: their high costs. The only equity asset class that is likely to make sense for holding in a VA is REITs — because their dividends don’t qualify for preferential tax treatment.   

Summarizing, the tax advantages and the availability of tax-efficient funds such as index funds, ETFs and tax-managed funds should typically lead investors to prefer to hold equities in taxable accounts. Additional discussion with your tax consultant is warranted.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2007, Buckingham Family of Financial Services.