Optimize Your Asset Allocation

There are three fundamental rules when it comes to investing:

-Pay attention to costs
-Minimize your taxes

Diversification helps ride out volatility, paying $7 commission on a $100 trade makes no sense and finally, paying Uncle Sam more than the absolute minimum means less money in your pocket!

This post is about minimizing what you owe Uncle Sam.

In order to minimize taxes, you should know what assets fit where.

Optimal Asset AllocationThere are two kinds of accounts – taxable and retirement account. Where you place your assets could mean a world of difference when you retire. Some assets are more suited for retirement accounts and some should be placed in a regular, taxable account.

Here’s a quick cheat sheet on where to place different kinds of assets and more importantly, why.

Gold, Silver And Other Precious Metals

Most optimal account: Retirement Account
Why? If held in a taxable account, the IRS treats gold and other precious metals as ‘collectibles’, which carry a 28% flat tax rate if held for more than a year and taxed at ordinary income tax rates, if held for less than a year. It would be most efficient to hold such assets in a retirement account.
Examples: GLD, IAU


Most optimal account: Retirement Account
Why? The distribution from a REIT asset is taxed as ordinary income and not as qualified dividend.
Examples: O, WSR


Most optimal account: Taxable Account
Why? MLPs if held in a retirement account can trigger Unrelated Business Taxable Income (UBTI) which involves additional paperwork and taxes. More importantly, most of an MLPs distribution is tax-deferred so keeping an MLP in a retirement account doesn’t make sense.
And in addition, by keeping an MLP in a retirement account, you lose one of the most attractive features of holding an MLP – the magic of diminishing cost basis!
Examples: KMR, ETP

Stocks That Don’t Pay Dividends

Most optimal account: Taxable
Why? If a stock doesn’t pay dividends, you don’t have to worry about taxes till you actually sell the stock!
Examples: GOOG, AMZN

Stocks That Do Pay Dividends

Most optimal account: Retirement
Why? Every time you receive a dividend, you are liable to pay taxes on it if kept in a taxable account.
Examples: AAPL, KO


Most optimal account: Retirement
Why? Bonds by its very nature pay dividends and hence would be more optimal if placed in a retirement account
Examples: BND

Royalty Trusts

Most optimal account: Taxable
Why? Royalty trusts have special provisions that allow the unit holder to reduce his/her cost basis by deducting expenses such as depreciation. By placing Royalty Trusts in a Retirement account, you lose this very important advantage.
Examples: BPT, SJT

I-Shares (Institutional Shares)

Most optimal account: Retirement
Why? I-Shares are special kinds of MLPs. The distribution is paid as additional shares avoiding a potential UBTI trigger, making it ideal for holding in a retirement account. Not all MLPs provide this option.
Examples: KMR, EEQ

Owning Shares Of Dividend Paying ADRs

Most optimal account: Retirement/Taxable
What? An ADR represents shares of a non-domestic company that are traded in a domestic exchange. IRS treats dividends from ADRs the same way as dividends from a domestic company…but, your dividends could be taxed by the ADR’s country of origin – this is called Foreign Withholding Tax. Even retirement accounts are not exempt from this. Not all countries do this though. The US has tax treaties with some countries like India and UK and for ADRs from these countries there is no withholding. For other countries, the rate varies greatly. Now withholding taxes can be recouped by claiming a foreign tax credit on your income tax if the ADR was held in a taxable account. For ADRs in a retirement account, there is no recourse.

It is a judgement call you have to make depending upon the tax rate and the dividend amount if a particular ADR should be placed in a taxable or retirement account.
Examples: UN, TOT

Mutual Funds With A High Turnover Ratio

Most optimal account: Retirement
Why? Turnover is the amount of buying and selling that goes on in a mutual fund’s portfolio. Why does that matter? Even if you don’t sell your mutual fund for a tax year, you’ll still be taxed on the mutual funds turnover gains! Such funds are best reserved for retirement accounts.
Examples: RYMNX, SCAPX

Exceptions To The Rule

Do you know that Mitt Romney has between $20 million to $100 million in his IRA? That’s $100 million of tax-free growth! How did he do it when the law limits contributions to an IRA? (Traditional and Roth IRA contributions are capped at $5500 as of 2013). We’ll never know! But I can speculate! Maybe he purchased shares of companies he incubated via Bain Capital – small, high growth companies that soon grew large and profitable.

Here’s a lesson for the rest of us. It might make more sense to place small, high growth companies in an IRA even though small companies typically don’t pay dividends.

Had you bought $5,000 worth of NFLX shares 5 years back by maxing out your Roth IRA, it would be worth more than …$86,000 today!

Closing Thoughts

Optimizing asset allocation isn’t complicated if you know the basic types of assets and the taxation rules for each type. Putting the wrong asset into the wrong account could potentially mean penalties, additional paperwork and most importantly, have less at retirement than what you could have had.

Of course, not everything can go into retirement accounts and unlike taxable accounts, there are limits on how much you can contribute. Make the most of what you have and place your assets appropriately.

It is better to stay invested than not to invest at all.

Please note that tax rates for this year (2013) has changed.

Free Practice Trading at optionsXpress

Checkout page 2 for a summary of 2013 tax rates.

14 thoughts on “Optimize Your Asset Allocation

  1. My understanding of the Romney IRA situation is that it was indeed related to his work at Bain Capital. However it wasn’t just buying shares straight-up. Rather, employees were allowed to purchase special shares that acted somewhat similar to options – cheap up front, very valuable if the underlying company does well, worthless if the underlying company does poorly.

    • Thanks for the snippet Steve! What you say makes a lot of sense. To accumulate so much so quickly would require MR to do something like this. He probably hedged his bets by buying into the IRA a little bit of number of companies Bain incubated.

      He had some good accountants by his side! :)

  2. Nice post, MC! I agree with Steve. This is why it is good to invest a growth company in IRA even if it doesn’t pay dividend.

  3. This is really helpful for people who are unsure of what type of account they should put their investments in. I’m a believer in the ROTH IRA because of the tax advantages it offers. Although in reality I may never be at a point where I can invest more than the $5500 annually you can put in a Roth IRA. If I do, I’m saving this post for that time.

  4. Hi Moneycone! Great to hear from you. :) This is a really helpful article. I didn’t realize there were this many different tax rules around capital gains. I guess I shouldn’t be surprised though with as complicated a tax code as we have in the US. Good to know about dividend paying vs non paying stocks. That’s probably what I encounter the most on this list.

  5. This is really important information. Saving on taxes by appropriately locating assets can save you a log of money. I’m going to include this one in a future round up!

  6. It’s so important to diversify. Good post.

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