Five Tax Moves for your Retirement
A Look at Tax Efficient Allocation
4.04.06

It is one thing to go on record suggesting that we take advantage of whatever retirement plan that is offered us. And I do this often quite often knowing that, in many instances, the company you work for will have such a limited selection of mutual funds and stocks that it almost seems to not be worthy of the trouble.

Tax efficiency is usually not on your mind as you sift through the plan's offerings. We tend to look at growth and performances, fees and management tenure, rankings and riskiness. We tend to look at everything but taxes. Which if you think about it, should be our first concern.

There is a strategy you should use in these tax deferred accounts before you look at all of those variables. In order to pick which ones will be best suited for you in this type of plan, one that is designed for long-term holdings, it might be better to discuss your possible tax bill in the future.

While death and taxes are often referred to as the only two things you can count in this life, knowing what your future tax rate will be is almost harder to predict than when you will expire. You can take steps to protect your health and well being, even rely on medical science to give you a longer life. We hear about actuarial tables being extended to accommodate our chances at prolonged life.

Much harder to predict is your tax rate. When 401(k) plans and Individual Retirement Accounts became popular, it was widely believed that in retirement, you would have a much lower tax rate. You would be earning less and because of that drop in real income, your tax bill would be substantially smaller. Now, with current deficits increasing each year and the simple fact that those bills will need to be paid, there might be something amiss with the lower rate theory.

Tax deferred plans allow you to put money away for the future when, if things turn out as planned, you will be taxed at a lower rate. One of the mainstays of 401(k) plans is the index fund. These funds make it easy for the less than experienced investor to buy into a broad basket of stocks, stocks and bonds, or just bonds. From a tax perspective, this is not a good idea. In the current tax environment, keeping index funds in a taxable account outside of a retirement account can be a better move.

For those of you that have a difficult time disciplining yourself to keep accounts outside of your tax deferred plan funded, making the best of what¹s inside your employer¹s plan is still the best choice. The ability to take a pre-tax deduction and more importantly, one made automatically can create something from a situation where there might be otherwise be none. But if you realize how much of your retirement is in your hands, you might find that discipline easier to embrace.

So which types of investments would be best kept inside a tax deferred account like a 401(k), a 403(b) or a traditional IRA? The answer is really all about the taxes each type of fund pays and whether deferring those taxes until a later time would be a wiser move.

Mutual funds that are actively managed should be inside your tax deferred accounts. Because of their high turnover and the possibility that the capital gains tax incurred because of frequent short-term selling, these types of funds would tend to generate a higher tax bill than investments held longer than a year. Keeping this tax bill inside your plan would offset any capital gains in the short term. As of right now, investments held less than a year are taxed at your marginal income rate while those held longer than a year receive a 15% bill

Some folks have taken popular advice and cycled some of their gains into high-yield junk bonds. If those gains are not inside a retirement account, the tax bill on these types of funds can come as quite the shock. Same suggestion goes for corporate bond funds, whose yields tend to be higher.

REITs or funds that hold them should be kept inside tax-deferred accounts. Real Estate Investment Trusts get a corporate tax break because of rules that force them to share 90% of the profit with shareholders. When these are held in some mutual funds and those funds trade those REITs frequently, the tax efficiency deteriorates rather quickly. Deferring this little tax issue until retirement will net you the best results tax-wise. .

The better retirement plans offer some brokerage services. If they do and they allow you to buy stocks other than you company¹s equity, use the account to buy stocks that you do not plan on holding for the full year. After holding a stock for twelve months, any gains on the stock can be considered long-term and are then eligible for the 15% tax treatment. Tax deferred accounts are better for short-term holdings.

Outside of these plans is a different story. Index funds, by far the prevalent offering inside tax-deferred accounts and the first choice for the conservative investor, are actually treated better outside these accounts. One reason is the lack of turnover.

These funds tend to be tied to an basket of stocks that only on rare occasion warrant rebalancing. Index funds are balanced to allow a predetermined exposure to certain stocks. An index like the S&P 500 does not hold equal amounts of each of the 500 companies it tracks. Instead they are weighted by percentage to allow for better overall performance and to some degree, a smaller amount of risk.

Sometimes these funds do need to be readjusted. Because it is so infrequent and when it happens it is done in a tax friendly manner, index funds are better held where the taxes are paid as the growth occurs.

Inside many company sponsored retirement plans, companies offer their own stock with the caveat that it cannot be traded until a certain age or when the employee leaves. This kind of 'buy and hold' strategy is better served outside of these plans. Using accounts outside your retirement plan to pick a basket of diversified, dividend paying stocks that are not included in any index funds you may be holding is a far better move for long term holdings..

Even though exchange traded funds are bought, sold and priced on the exchanges each day, they should be held for longer than a year to take full advantage of what they offer. ETFs also hold a basket of equities that are not taxed until you sell them. Taking the 15% after twelve months allows you the best of what could be a highly taxable situation.

Holding municipal bonds and funds that trade them are best suited for the long term and should be kept outside of your tax deferred accounts. In many instances, these funds can be tax-free in some states which would make their tax treatment much more favorable in an account where the taxes have already been paid, such as a Roth IRA.

So considering these tax consequences, the following five steps should be taken when investing:

1. Index funds and funds with little turnover should be held outside of a tax deferred account. Look at your funds turnover ratio. If it is be less than 50% over a twelve month period or less, it is probably tax efficient and should be kept outside of your tax deferred accounts. Some balanced funds may also qualify.

2. Consider the real yield on your bonds and bond funds. Corporate bond funds, high yield junk bond funds, and other bonds with healthy yields should be kept inside tax-deferred accounts. Taxed at current rates can seriously impact those yields.

3. REITs have special tax considerations. If they are owned inside a mutual fund, and they are traded frequently, capital gains can begin to mount in spite of the generous distributions. Keep them inside your retirement plans and defer the tax consequence.

4. Stocks you plan on holding should be kept outside retirement plans; actively traded stocks will get better treatment inside these plans.

5. ETFs, despite how easy they are to trade, should be held for the long term. Keep these outside of your tax deferred accounts. Many ETFs are indexed and have the same tax considerations as index funds. Some however have become increasingly focused on specialized sectors. The only time an ETF should be inside a retirement plan is when they are so narrowly focused they may create some outsized gains, tempting you to relinquish your position for profit taking.