Last month, I sold all the shares of a couple of stock mutual funds in my traditional individual retirement account and used the money to buy bonds for the IRA. That same day, I used some of my cash reserves to buy the exact number of shares of the same stock funds in a taxable account outside the IRA.
While there are no tax consequences now, I figured the switch could save me quite a bit in taxes in the long run. I have since read a paper from a professor that validates my tax strategy but argues I had unwittingly increased my asset allocation to stocks (which was OK, as my allocation was low).
The rationale: Because I will have to pay taxes when I withdraw the money from the traditional IRA, the government in effect "owns" some of it. Since I expect to be in the 15 percent tax bracket, for every $1,000 I withdraw I will keep only $850.
Therefore, when totaling my investments and figuring out an asset allocation, I should count only 85 percent of the money in my traditional IRA and other tax-deferred accounts, such as my self-employed 401(k) in which taxes will eventually be due. (I can count all my Roth IRA money because none of it will be taxed.)
"The traditional approach to asset allocation, failing to distinguish between pretax and after-tax funds, tends to exaggerate your allocation to whatever is in your tax-deferred accounts," said William Reichenstein, a professor at Baylor University in Waco, Texas, who wrote the paper for the July issue of the Journal of Financial Planning.
Reichenstein is also a frequent contributor to the AAII Journal of the American Association of Individual Investors, where he has made a similar point.
For example, under the traditional approach, a portfolio consisting of $100,000 in stocks in a traditional IRA and $100,000 in bonds in a taxable account is seen as having a 50 percent stock and 50 percent bond allocation. But if you count only $85,000 of the money in the IRA (assuming a 15 percent tax bracket on withdrawal), the "after-tax" allocation is 46 percent stocks ($85,000 of $185,000) and 54 percent bonds.
This view is far from universally accepted. Calculating an after-tax allocation is complicated by factors such as unrealized paper gains or losses on taxable investments, how long such investments are held, and uncertainties about future tax rates.
But Reichenstein, a chartered financial analyst and author of more than 100 articles for professional and academic journals, argues his approach provides a more accurate picture of an investor's asset allocation, portfolio risk and expected return.
"I'd rather be approximately right than precisely wrong," he said (that is, estimating the effect of taxes rather than ignoring them). At the very least, Reichenstein's method will make investors appreciate the tax implications of their decisions.
Investors should first determine an after-tax asset allocation consistent with their goals and risk tolerance, Reichenstein said. They should also maintain enough liquid reserves in stable investments (such as for emergencies).
Within the context of their overall allocation and liquidity needs, investors, in general, should put bonds in tax-deferred accounts and put stocks - particularly stocks they intend to hold for many years, or tax-managed stock funds that minimize capital-gains distributions - in taxable accounts.
That's because long-term gains from stocks in taxable accounts qualify for capital-gains rates, which are lower than the ordinary income tax rates for traditional IRA withdrawals - even when those withdrawals include gains from the sale of long-held stocks and stock funds.
Humberto Cruz writes for Tribune Media Services.