Q&A: Investment and Tax Strategies Across Accounts

The different tax structures of the various account types - traditional, Roth, and regular taxed brokerage accounts - should be taken into consideration when planning your investment strategies. How do we take advantage of these different account types, all while maintaining a balanced portfolio? The answer is to break up your asset classes into each type of account, rather than trying to make each one roughly balanced. It can be advantageous to hold certain asset types in each account type. I'm going to keep things relatively simple and talk just about stocks, bonds, mutual funds, and ETFs (and a bit about options, I suppose, but not commodities or specifics on market capitalizations and whatnot).

• Stocks - Your basic stock has dividends and stock price appreciation. While some stocks are chosen for their dividend yield, when we talk about stocks, we usually are focused on stock price appreciation as a goal. For stocks that are held longer than a year, we expect/hope that the majority of our profits are the result of stock price appreciation. This will result in long term capital gains, which is always taxed at a lower rate than regular income tax.


• Bonds - Bonds have coupons and price, which taken together produce a yield. Because the coupon (the interest rate) doesn't change, price and yield are inversely proportional. While the price may go up and down while you hold the bond, your yield is locked in when you buy the bond. We are usually focused on this yield, which provides a steady stream of income (and is taxed as such). Bonds are a more conservative investment, where yields are expected to be lower than the average return of stocks, but with less risk.


• Mutual funds - Mutual funds provide a convenient way of diversification. Owning a share of a mutual fund gives you an ownership stake in all assets the fund holds. You also own a share of the profits, and the taxes due on those profits. The form of those profits - short term or long term - are mostly under the control of the fund manager, and may not be ideal for your current tax situation. Some funds are actively managed and change their assets often (have high turnover). These funds tend to have a lot of realized gains every year, and behave more like bonds, tax-wise. Other funds are passively managed, or tax managed, and do their best to avoid gains that have to be passed on to the shareholders. These funds tend to have fewer realized gains per year, and behave more like stocks, tax-wise. The performance of mutual funds depends on the assets it invests in.


• ETFs - Exchange-traded funds (ETFs) are like mutual funds, but all ETFs follow an index, and so are like passively managed mutual funds. They also don't have to buy or sell their underlying stocks as often as mutual funds, and instead do in-kind trades, which the IRS doesn't tax. So, ETFs generally behave more like stocks, tax-wise, than mutual funds, but there are a few ETFs that aren't as tax-efficient as their mutual fund peers, but these tend to be mutual funds that themselves already behave as stocks. More information, for anyone who wants it.


• Options - Options include your two basic types of options contracts - puts and calls. A put option is merely a contract to buy a block of shares (usually 100) at a given price. Similarly, a call option is a contract to sell a block of shares at a given price. Most options trades are for short term contracts, and are therefore short term gains taxed at high rates. For example, so far all of my options profits and losses have been short term. Options can be used to add extra value to owned stocks, insure an equity position, or put cash to use, but either way, gains (and/or losses) are expected to be relatively large.

With our asset types defined, we can now match them with their ideal account type. First, let's take a quick look at how much of your portfolio each should be. Unfortunately, there's no single answer. Each investor has to decide for themselves what level of risk they are willing to accept in their pursuit of returns. Common stock/bond ratios are 80/20, 70/30, and 60/40. This can be achieved through mutual funds and/or ETFs, or directly through individual stocks and bonds - with individual stocks and bonds being more risky. The percentage of your portfolio invested in bonds usually increases as you approach retirement, as well. Because I am young and have time to make up any losses I might suffer, I have decided to be risky and have nearly 100% stocks, including some individual stocks. I also use some options trading, which has definitely been risky.

• Brokerage accounts - Regular brokerage accounts are taxed as often as possible. Every trade in the account is subject to income or capital gains taxes, as applicable. They are not tax advantaged at all. Consequently, brokerage accounts lend themselves to few trades that result in long term gain. From above, that would be ETFs and stocks - specifically stocks that are good buy-and-hold stocks.


• Traditional accounts - Traditional retirement accounts are taxed as regular income when you take the money out, but grow tax free. I think traditional accounts are ideal for the bond portion of your portfolio. Bonds are full of short term gains that we can avoid the tax on, and aren't expected to produce returns as large as other investment types, which means our tax at retirement will be lower. Perfect!


• Roth accounts - Since Roth accounts grow tax free and end tax free, I find them to be ideal for my more aggressive investments. As I said, most of my portfolio is made up of stocks, but if I did have bonds, I would try to keep them out of my Roth accounts. Also whenever possible, I do my options trading in a Roth account.

So, to summarize, I would like my Roth accounts to contain mostly aggressive stocks and mutual funds, my traditional accounts to hold mostly bonds and bond-like mutual funds, and my brokerage accounts to contain mostly stable stocks and ETFs, or tax-exempt bonds/mutual funds. Of course, it's not always easy to allocate things between traditional and Roth accounts. For example, my 401(k) plan has a limited number of investment options - all mutual funds (or IBM stock). To make things more challenging, my 401(k) does not make it easy to consolidate information on which assets are in traditional versus Roth accounts, and managing separate investment allocations between pre and post-tax accounts is not automatic. Thus, I have not implemented any special treatment for the traditional side of my 401(k) as of yet. If your IRA account is through a financial planner, they may only offer mutual funds, or hands-on trading may be impractical. It was for the latter reason that I transferred my Roth IRA to E*TRADE. This gave me access to thousands of mutual funds and ETFs, along with individual stocks and bonds. It also let me take advantage of options trading opportunities tax free.

In my next post, I will take a look at the relative priority of each type of account, and my thoughts on spacing contributions throughout the year.