Asset allocation and tax efficiency

Question

Common advice for asset allocation to increase tax efficiency is to:

• Put bonds in tax-advantaged accounts (401k, Roth IRA, etc)
• Put stocks (e.g., S&P 500 ETF) in regular brokerage accounts

The reason behind this advice is that bond dividends are taxed at higher levels than capital gains. (See the Boglehead book for details)

I've been doing this for many years, and my brokerage accounts have grown a lot (thanks to amazing stock growth over the last 10 years) and my tax-advantaged accounts have grown very slowly (because of low interest rates). I have 60/40 split with stocks/bonds. Tax-advantaged accounts are all bonds and I have some bonds in the brokerage account.

There are two downsides to the current situation:

1. I'd like to have more money in my tax-advantaged accounts to get better tax advantages.
2. More importantly, when I need to rebalance by selling stocks and buying bonds, it is a taxable event and I'd rather defer those taxes until retirement.

Would I get a better tax advantages if I ignore this common advice and put some stocks in tax-advantaged accounts? Or even completely reverse the advice and put all my stocks in tax-advantaged accounts?!?

Answer 1

Would I get a better tax advantages if I ignore this common advice and put some stocks in tax-advantaged accounts?

You can take the bonds in the tax advantaged accounts, sell them ,and then buy stocks or stock mutual funds inside the tax advantaged account.

You should try to use the funds inside the 401(k)/IRA to bring you back to balance. You do this because the selling of one investment and the buying of another investment does not trigger current year taxes if done inside these accounts.

Answer 2

"I'd like to have more money in my tax-advantaged accounts to get better tax advantages." - How would asset allocation change this? Stocks that are appreciating in value are tax deferred under either a normal brokerage or a tax-advantaged account. Bonds that give you income are taxable in a brokerage account and not taxable in a tax-deferred account

"More importantly, when I need to rebalance by selling stocks and buying bonds, it is a taxable event and I'd rather defer those taxes until retirement." Why not just not strictly follow your allocation rules if it will trigger a taxable event? If you are consistently putting money into the brokerage/tax-deferred accounts, than just use that money to get back into balance. Having a good asset allocation strategy is useful, but I don't know why following it to a T is worth paying taxes over.

Even if I take it for granted that you must follow the asset allocation perfectly, then income taxes on dividends vs the capital gains tax on stock sold to rebalance would favor the strategy you have if you are forced to rebalance in an 'average' year. For example, if you have a 60/40 portfolio where stocks appreciate 8% and bonds yield 2%, you end up with a 61.4/38.6 ($64.80 and $40.80 respectively) portfolio at the end of the year. If you have to rebalance, then you need to sell $1.44 of stock, which will trigger $0.22 of taxes at a 15% capital gains tax. If the $0.80 of bond income was taxable at a 32% income tax rate, then you would have had to paid $0.26 if the bonds were in a taxable account. You'd be better off as your doing it; you can vary the stock appreciation, bond yield, and income tax rate to see what various scenarios would produce. A year like last year where you have 20+% of stock appreciation will favor putting stock into a tax deferred account if you are forced to rebalance.

Again, though, I would just recommend NOT triggering taxable events for the sake of rebalancing a portfolio and keeping it as you have it.