How to Keep More — The Tax Factor in Your Asset Allocation

Thinking about asset allocation, what comes to my mind is the distribution of different asset classes in my portfolio: large-cap, small-cap, mid-cap, bonds, real estate, commodity, international, ect. There's hardly any doubt about the importance of asset allocation in investing. However, there's one more factor that we may have omitted so far: the taxes.

When I use such tools as Morningstar's Instant X-ray to check the asset allocation of my mutual funds, what I use are the market value of each fund and the tool will take the face values to determine the percentage of each asset class across the entire portfolio. Nothing else is considered. Now, assume that I have a very simple portfolio with only stocks and bonds and my target allocation is 70% in stocks and 30% in bonds. And at this time of the year, I already had about 10% of gains in stocks due to dividend/capital gain payouts that are reinvested. If I X-rays my portfolio and it tells me I have the exact allocations I want, should I be happy about it? Not really, at least according to a Reuters article I read a week ago. What's missing from the X-ray result is the taxes that I will pay on those distributions. Since the taxes are paid separately and I won't subtract that amount from the market values, the allocation percentages I get may not represent the real picture.

According to the article, Prof. William Reichenstein at Baylor University in Waco, Texas in a paper published recently in Financial Analysts Journal, concluded that "Financial managers who use the traditional approach to calculate individuals' asset allocations are miscalculating their true allocations. The … errors can be substantial."

To make sure that you're keeping more of what you're making, first understand that different investments have different tax treatments.

  • Interests, real estate gains, bond dividends, and gains from stocks held for less than a year will be taxed at your regular income tax level, which could be as high as 30%. Investments generating these high-tax gains should be put in tax-deferred accounts if possible.
  • Dividends from securities held for 60 days or more will be taxed at maximum rate of 15%. Growth stocks, ETFs, or index mutual funds can be put in regular taxable accounts as they won't have heavy taxable distributions.

To get the right allocation on an after-tax basis, the article suggests two steps:

  1. Guesstimate future taxes. It's hard to come up with a future tax figure if you're still many years away from retirement, but worth considering anyway, even if only for a rough estimate.
  2. Calculate your own optimum asset allocation based on how much the investments are worth after their taxes are applied.

Finally, the article reminds us that

putting the right asset in the right account and being mindful of future taxes when deciding how much of an asset to buy will help you in the long run.

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