Asset Allocation and Taxes Made Simple

You already know that you need to save and invest a large amount of money to retire early. Where should you invest your money and what type of account is best for each type of investment. Here is how I split up my portfolio among various asset classes and accounts.

Allocation to Stocks

Most people know that investing in stocks will give you the largest return over a long period of time. The first step is to decide how much of your portfolio you would like allocated to stocks. This allocation is a personal choice based on risk tolerance and therefore there is no correct answer. For my example I am going to assume a 60% allocation to stocks. The remaining 40% should be allocated to bonds.

Account Types

Asset Allocation PieWhen investing for retirement the main account type is a tax-deferred account (401k, 403b, IRA). Tax-deferred accounts allow you to invest pre-tax money and the investments in your account grow without paying taxes. Taxes will be paid on your entire tax-deferred account when you start to withdraw funds. For people planning to retire early, you will also need to invest in taxable accounts because there is a limit on how much you can contribute to tax-deferred accounts. For my example I am going to assume that 60% of your assets are in tax-deferred accounts and 40% are in taxable accounts. It would be easy to just put the 60% stock allocation in the tax-deferred accounts and the 40% bond allocation in the taxable accounts, but that would most likely be a sub-optimal approach.

Taxation of Bonds

Bond interest is taxed as ordinary income (your highest tax bracket) when you receive it. Over the long-term bond interest rates are higher than dividend rates from stocks. For this reason the tax efficient investor would hold bonds in the tax-deferred accounts so that current taxation is reduced.

Taxation of US Stocks

Qualified dividends from stocks are taxed at the capital gains tax rate. For some investors this can be as low as a 0% tax rate. For all investors the capital gains tax rate is lower than the ordinary income tax rate. For maximum tax efficiency you should invest in a stock index fund that pays out primarily qualified dividends. Many funds are available that pay out close to 100% of dividends as qualified. The tax efficient investor will prefer having stocks in a taxable account over bonds.

Taxation of International Stocks

For diversification purposes, many individuals hold international stock in their portfolio. International stocks are taxed similar to US stocks. However with international stocks you may also be able to take a tax credit for the foreign taxes paid by the mutual fund you are investing in. This tax credit is essentially lost in tax-deferred accounts. For this reason, the tax efficient investor would prefer to hold international stocks in their taxable accounts so that they can take the tax credit. For my example portfolio I will assume that you invest 30% of your total stock allocation in international stocks. This equates to 18% (60% x 30%) of your total portfolio.

Sample Portfolio Asset Allocation and Asset Location

Asset AllocationThe pie chart shows an example of a sample portfolio from the concepts detailed above. The taxable account is invested in the entire international stock allocation and a part of the US stock allocation. The tax-deferred account is invested in the entire bond allocation and a part of the US stock allocation. I hope that this post has given you some ideas to think about when designing your portfolio’s asset allocation. You should also now understand the basic tax considerations for asset location in your portfolio. As always, consult your personal investment and tax advisor for information specific to your personal situation.

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