Lessons from the Pros

Proactive Investor

Tax Strategy for Allocating Investments

Today I want to talk about a tax-related issue that applies to many if not all, investors – the allocation of funds to minimize taxes.

The Goal of Diversification

Different kinds of investments provide different levels of returns, each with its own particular risks. In general, investments that generate returns whose long-term average is high (stocks, real estate) do so in a very uneven fashion, with some years showing big gains and others big losses. Other investments whose returns come mainly from interest or dividends (cash, bonds, preferred stocks) have lower long-term average returns, but much less year-to-year variation.

The best way to combine the virtues of high-yielding but riskier investments (let’s call this the Variable – Growth investment category) with those of lower-yielding but safer ones (the Steady Income investment category) – is to put some money into each category. This is the goal of asset allocation. Asset allocation is a large subject in itself, but let’s assume a simple situation so that we can then layer on the tax strategy.

Allocating Assets to Minimize Taxes

Jane is 40 years old with an income of $10,000 per month. She has accumulated savings and investments of $500,000. She has just completed her Strategic Investing class and is ready to begin implementing her investment strategy. She has decided that of the $500,000 total, she would like to allocate it in this way:

  • A three-month buffer of $30,000 in cash.
  • 60% of total assets to be invested in Variable – Growth
  • The rest will be in Steady Income

Her desired asset allocation looks like this:

Asset Allocation based on Age and Income
Example: 40 years old, $10K/Mo Income

Asset Type Amt to Allocate Amount
Cash 3 Mos income $30,000
Variable – Growth 60% $300,000
Steady Income The Balance $170,000
Total $500,000

Like many people, Jane’s capital is divided between accounts with different tax statuses, so she needs a strategy for minimizing taxes to accompany her investment risk allocation strategy. She has some money in her employer’s 401(k) plan (tax-deferred), some in a traditional IRA (also tax-deferred), some in a Roth IRA (tax-free) and some that is in a brokerage account where the income and gains are fully taxable every year.

Current Distribution of Total Investments by Tax Status

Description Tax Status Amount
Employer’s 401(k) Deferred $180,000
Traditional IRA Deferred $75,000
Roth IRA Tax-Free $125,000
Taxable Taxable $120,000
Total $500,000

Of course, Jane wants a tax strategy so she can pay the lowest total in taxes that she possibly can on the income and gains from her investments.

The guiding principal from a tax standpoint is to attempt to earn the most where it will be taxed the least, and earn the least where it will be taxed the most. That would mean putting the assets that are expected to earn the most into the Roth IRA, where the gains are not taxed at all; then in the 401(k) and traditional IRA, where the taxes are deferred; and finally the lower earners (Steady Income) in the fully taxed environment. This would give the best chance of minimizing her total taxes.

How can Jane apportion the assets in each tax status so that she can get as close as possible to accomplishing the risk allocation she wants? Here’s an example asset allocation tax strategy.

Step by Step Example of Implementing a Tax Strategy in a Diversified Investment Portfolio

Step 1: Creating a Worksheet

Create a worksheet listing allocation amounts by asset type. Leave room to spread each asset type by tax status. This would look like this:

Asset Allocation based on Age and Income
Example: 40 years old, $10K/Mo Income

Spread by Tax Status

Asset Type Amount to Allocate Dollar Amount Roth IRA Employer 401(k) Traditional IRA Brokerage (Taxable) Bank (Taxable) Total
Cash 3 Mos income $30,000
Variable/Growth 60% $300,000
Steady Income The Balance $170,000
Total $500,000 $125,000 $180,000 $75,000 $90,000 $30,000

Step 2: Allocate Assets into Tax Free Investments First

Begin allocating assets by first allocating all, or as much as possible, of the tax-free funds to the highest-earning assets. Jane allocates the full balance of the Roth IRA to the Variable – Growth assets. Her sheet now looks like this:

Asset Allocation based on Age and Income
Example: 40 years old, $10K/Mo Income

Spread by Tax Status

Asset Type Amount to Allocate Dollar Amount Roth IRA Employer 401(k) Traditional IRA Brokerage (Taxable) Bank (Taxable) Total
Cash 3 Mos income $30,000
Variable/Growth 60% $300,000 $125,000 $125,000
Steady Income The Balance $170,000
Total $500,000 $125,000 $125,000

Step 3: Complete Tax Free Allocation and Begin Tax-deferred Allocations

Allocate the funds in the employer 401(k) (which are tax-deferred) to the growth-oriented assets as far as possible. Allocate the rest of the 401(k) balance, if any, to the Steady Income asset category.

Jane has $180,000 in her 401(k). There is room for $175,000 of that in the Variable – Growth category before the $300,000 maximum for that category is reached. The remaining $5,000 in the 401(k) is allocated to Steady Income assets. The status is now:

Asset Allocation based on Age and Income
Example: 40 years old, $10K/Mo Income

Spread by Tax Status

Asset Type Amount to Allocate  Dollar Amount Roth IRA Employer 401(k) Traditional IRA Brokerage (Taxable) Bank (Taxable) Total
Cash 3 Mos income $30,000
Variable/Growth 60% $300,000 $125,000 $175,000 $300,000
Steady Income The Balance $170,000 $5,000 $5,000
Total $500,000 $125,000 $180,000 $305,000

Step 4: Complete Tax-deferred Allocations and Begin Taxable Allocations

Allocate the funds in the Traditional IRA (tax-deferred) to the growth-oriented assets as far as possible. Allocate the rest of the IRA, if any, to the Steady Income asset category.

Jane has $75,000 in her IRA. But there is no more room in the Variable – Growth category. The IRA money must go into Steady Income. New status:

Asset Allocation based on Age and Income
Example: 40 years old, $10K/Mo Income

Spread by Tax Status

Asset Type Amount to Allocate  Dollar Amount Roth IRA Employer 401(k) Traditional IRA Brokerage (Taxable) Bank (Taxable) Total
Cash 3 Mos income $30,000
Variable/Growth 60% $300,000 $125,000 $175,000 $300,000
Steady Income The Balance $170,000 $5,000 $75,000 $80,000
Total $500,000 $125,000 $180,000 $75,000 $380,000

Step 5: Complete Taxable Allocations

This leaves just the money in the taxable brokerage account, and the $30,000 of cash to put in the bank. After making those allocations, the completed sheet is as follows:

Asset Allocation based on Age and Income
Example: 40 years old, $10K/Mo Income

Spread by Tax Status

Asset Type Amount to Allocate Dollar Amount Roth IRA Employer 401(k) Traditional IRA Brokerage (Taxable) Bank (Taxable) Total
Cash 3 Mos income $30,000 $30,000 $30,000
Variable – Growth 60% $300,000 $125,000 $175,000 $300,000
Steady Income The Balance $170,000 $5,000 $75,000 $90,000 $170,000
Total $500,000 $125,000 $180,000 $75,000 $90,000 $30,000 $500,000

With this set of facts, this is as close as Jane can get to her ideal asset allocation from a tax standpoint. It would have been preferable not to waste the tax deferral on the $75,000 allocated to the Traditional IRA, but the Variable – Growth bucket was already full. So, rather than overriding her risk allocation to garner additional tax benefits, Jane invested the $75,000 in the Steady Income investment category. Following her strategy for allocating assets by risk category (riskier Variable – Growth vs. modest but safe Steady Income) takes precedence over tax considerations, which is an important lesson for investors to learn.

How to Implement and Maintain an Asset Allocation Strategy

Now that Jane’s allocation plan is complete, her next task is to implement it. This means possibly making some changes within each of her accounts to bring that account into alignment with the plan.

For example, if in her employer’s 401(k), the current allocation of the $180,000 total is $120,000 in stock funds and $60,000 in bond funds, a transfer is in order to bring that allocation to $175,000 / $5,000 as shown in the plan. Jane would need to move $55,000 from the bond fund to the stock fund.

Each of the other accounts will need to be adjusted as well. Then Jane is ready to run her own mini-hedge fund for the next year.

Free Trading WorkshopIn the future, Jane will need to revisit her allocations once a year. Part of her ongoing Strategic Investment plan is to review her situation annually to see if any changes to her asset allocation are called for. At those times she will need to re-balance the buckets as their proportions naturally change in response to their different performance levels. Now that she has the structure within which to make these changes, these steps will be fast and easy in the future. For more information on a Strategic Investing Class, please contact your local center.

I hope you find that structure beneficial for yourself as well.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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