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Taxable vs. Tax-Deferred: How to Choose Your Ideal Asset Allocation

One of the common questions people always ask when building their investment portfolio is how to choose between tax-deferred and taxable accounts.

First, let’s get one thing out of the way: the answer to this question is not to put all of your money in one of these buckets. Each one has pros and cons, so you’re going to want to have some money in both of them. The biggest question is: how much?

What is a Taxable Account?

A taxable account is one in which you invest after-tax dollars. That means that the money going into them has already had federal income tax deducted from it.

Technically, you could probably call a high-interest savings account a taxable account, but that isn’t what we’re concerned with here.

Usually, when you hear of a “taxable” account, it refers to an individual investment account. The most common type of these is a brokerage account with an investment firm such as Vanguard, Schwab, or Fidelity.

But those accounts are just buckets. In the buckets will be your investments; you can invest in whatever you want. Of course, there are many different strategies, but we typically recommend either dividend stocks or index funds.

As a rule, tax-efficient investments should be held in taxable accounts. These include funds such as total-market stock funds.

What is a Tax-Deferred Account?

A tax-deferred account is one on which you pay no taxes when the money goes in (including income tax). In addition, the money in tax-deferred accounts grows tax-free, meaning you don’t have to pay taxes on your investments as long as they are sheltered in a tax-deferred account.

You only pay taxes on these accounts when you take money out, at which point, it’s taxed as regular income. That means tax brackets apply.

The most common types of tax-deferred accounts are 401(k)s and traditional IRAs. However, it also includes accounts such as the 457(b) and 403(b).

Your tax-deferred accounts should hold tax-inefficient investments. These include investments such as bond funds and REITs. That’s because these funds mostly pay out in the form of dividends (as opposed to growth), so deferring taxes will be less costly.

If you want a further breakdown of which type of funds to hold in which accounts, Bogleheads has a great graph that illustrates this.

Bonus: Tax-Free

For the most part, investing comes down to taxable or tax-deferred. However, there are a couple of ways you can potentially avoid taxes altogether.

The first is if you hold your investments in a health savings account (HSA). In order to have one, you must have a high-deductible health plan (HDHP), either through your employer or by buying one yourself.

If your employer offers health insurance, though, but not an HDHP, it probably won’t be worth it to get an HDHP on your own.

But if you can get an HDHP and an HSA, the money won’t be taxed going in or when coming out. Plus, you can hold investments in them.

Currently, the contribution limit for HSAs is only $3,500 ($7,000 for families), but it might be worth considering for the tax savings it offers.

Taxable vs. Tax-Deferred vs. Tax: Free – How Do You Choose?

As mentioned in the introduction, the answer to this question is not to choose one or the other. In fact, the answer largely depends upon your individual goals, risk tolerance, and other factors.

Therefore, we’ll break down some of the things to consider when determining your ideal asset allocation.

Tax Efficiency

Yes, tax efficiency is always a big concern when determining your asset allocation. There are a number of reasons for which some assets are seen as more tax-efficient than others.

According to Bogleheads, “Some fund types, like total market stock index funds, are extremely tax-efficient, because they produce low dividends (that are mostly qualified) and capital gains. By contrast, bond funds can be extremely tax-inefficient, because the interest they produce every year is taxed at your full marginal tax rate…Put tax-inefficient funds into tax-advantaged accounts to the extent possible.

There’s a lot of information here, but the last line is in bold because that is the key in all this.

The reason you would want to hold bond funds in a tax-deferred account is because bonds pay out in the form of dividends, which are taxed as income. The result is that holding them in tax-deferred accounts allows you to defer taxes on bonds and bond funds.

The problem, though, is that tax-deferred accounts, such as 401(k) accounts have contribution limits. If you are in the growth phase and your growth strategy is primarily index funds, you will want to take advantage of tax-deferred and tax-free accounts first in order to grow your money as much as possible.

If you are able to invest enough to hit the 401(k) contribution limit, and you are growing your net worth with index funds, you may not want to prioritize bond funds in your tax-deferred accounts.

Thus, despite the above quote from Bogleheads, things are complex, and you’re going to have to make some personal decisions in terms of where to put which assets.

Tax Brackets

One of the benefits of having your money in both taxable and tax-deferred accounts is that it lets you “play around” with tax brackets when withdrawing your money.

If you have a large amount of money in both taxable and tax-deferred accounts, only the money in the tax-deferred accounts will be taxed as income when withdrawn. The benefit of this flexibility is that keeping your taxable income low means you can also stay in a relatively low tax bracket.

Here are the 2020 tax brackets, per TaxFoundation.org:

RateFor Single Individuals, Taxable Income OverFor Married Individuals Filing Joint Returns, Taxable Income OverFor Heads of Households, Taxable Income Over
10%$0$0$0
12%$9,875$19,750$14,100
22%$40,125$80,250$53,700
24%$85,525$171,050$85,500
32%$163,300$326,600$163,300
35%$207,350$414,700$207,350
37%$518,400$622,050$518,400

This means that, for example, if you keep your taxable income below $40,125 in 2020, your tax rate will only be 12%.

Also, keep in mind that marginal tax rates apply. What does that mean? Using the table above, let’s say your taxable income in 2020 is $100,000. That puts you over the $85,525 bracket, but that doesn’t mean you pay 24% on all of that income! Instead, you pay the following:

  • $14,475 taxed at 24%
  • $45,400 taxed at 22%
  • $30,250 taxed at 12%
  • $9,875 taxed at 10%

This is due to marginal tax rates. You don’t pay percentage matching your tax bracket on the entire amount; instead, you only pay the tax rate above that tax bracket, while paying the lower tax rates on the lower brackets.

In any case, lower taxable income will always result in lower taxes overall.

Future Income

Another important consideration when determining your taxable vs. tax-deferred strategy is your future income. In other words, what will your income be in retirement?

You will often hear that you should plan to have about 80% of your current income in retirement, but, of course, you have a say in that percentage. This is especially true if you expect to retire early. If you put a large portion of your money in taxable accounts and Roth IRAs, you can reduce your taxable income in retirement since you will have already paid taxes on that money.

The other consideration is what kind of lifestyle you want to live after you retire. If you plan to live a lifestyle similar to “the American dream,” you’re going to have relatively high expenses.

But many FIRE people decide to drastically reduce their living expenses in order to retire earlier. If you maintain those lower expenses after retiring, your income in retirement could be much lower than it is today and still be more than enough.

Plus, lower income = lower tax rates! At the end of the day, your post-retirement income and expenses will have to align with your personal goals and values. Just know that needing 80% of your $60,000 income in retirement isn’t necessarily a given.

Future Tax Brackets

Another thing that can have a big influence on our investments, but over which we have little control, are future tax rates.

For example, if we knew tax rates would be higher in the future, it might make sense to load up on Roth contributions (both IRA and 401(k)/others) because you pay taxes on Roth contributions when money goes in, but not when it comes out.

Unfortunately, no one can really predict future tax rates accurately, not least because we don’t know what laws future administrations may decide to pass. The result is that it’s probably best to invest based on what you would like your withdrawals to look like in the future rather than on hypothetical tax brackets.

Roth Conversions

Another thing that will affect your retirement savings is Roth conversions – if you decide to do them.

If you aren’t familiar with Roth conversions, here’s the basic idea:

  • Contribute to a traditional IRA (thus paying no taxes on contributions).
  • Five years before you’ll need the money, move it to a Roth IRA (you must wait five years; otherwise, you’ll pay a 10% penalty).
  • Withdraw from the Roth IRA.

There are several things to consider before doing this. The biggest thing is that you must pay taxes on the contributions when moving the money to a Roth IRA. That is because Roth IRAs can only hold after-tax dollars.

However, there is one reason you might decide to do Roth conversions despite all this. Let’s say you have 80% of your investments in tax-deferred accounts such as a traditional 401(k). If you want to access that money early, you could roll it into a rollover IRA, then convert it to a Roth.

You would still have to pay taxes when converting, but if you end up retiring earlier than you expected, it could be a necessity. You do pay higher taxes on conversions than you do if you simply withdraw from a traditional IRA, so that’s something you should know.

If you aren’t retiring early, Roth conversions really only make sense if you expect your income in the future to be higher than it is currently. After all, that money will be taxed as income when you convert. Plus, remember that conversions will be taxed at a higher rate.

It’s About Your Goals

In order to formulate a strategy around where you should hold your investments, you should answer questions such as what your goals are, when you want to retire, and how much income you want to have in retirement.

If you want to retire early, you’ll need to have a larger portion of your money that is accessible before the traditional retirement age. Whether that is by loading up your taxable accounts or through Roth conversions, you’ll want to be sure you have enough cash available.

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