15.5.0 Introduction

             At this point, we have discussed the majority of readily available tax shelters and how they generally fit into a financial plan. We must now consider where to allocate specific funds. For example, consider an individual, Kevin. Kevin is 40-years old and would like to allocate his portfolio so that 65% of invested funds are held in US stocks, 20% in international stocks, and 25% in bonds. While we could quibble over the specifics, this seems like a perfectly cromulent portfolio mix. But, how should this asset mix be distributed among their accounts? The answer to this question is, perhaps surprisingly, one of the most complex topics we cover in this class. In this chapter, I provide a recommendation that will apply for most. But if your income is very high, you have lots of assets, or reside within a state with high state-level taxes, it’s plausible that my recommendations are sub-optimal.

15.5.1 Creating an Action Plan

Let’s create an order of operations. If you traverse through action plan described below, your finalized investment allocations will be tax efficient, in most cases.

Action 1:  Place your International Stocks in a Brokerage Account

             International stocks receive a bizarre tax treatment and the terms can get extremely confusing.[i]  But in most cases, it’s preferable to hold foreign investments in a brokerage account. Why? When you hold international stock in any tax shelter, the dividend earnings are subject to foreign taxes. However, when you hold international stocks in a brokerage (taxable) account, the foreign taxes paid on dividends can be avoided by claiming a foreign tax credit. If you use standard tax software (e.g. TurboTax or TaxSlayer), the value of this tax credit should be automatically applied to your final return.[ii]  The table below compares tax treatments of the three major asset types: 

As indicated, you don’t get some amazing tax savings by holding international stocks in a brokerage account. US stocks and international stocks held in a brokerage account are both subject to US income taxes. But because international dividend earnings are subject to foreign taxes when held in a tax shelter, it’s usually wise to allocate international stocks to your brokerage account. So, if you have a brokerage account and you want to hold international stocks somewhere within your asset mix, it’s best to place your international stocks in the brokerage account.

Action 2:  Place your US stocks in Roth accounts

             Now that international stocks have been placed in their rightful place, we can compare US stocks versus bonds. Since we expect the return from stocks to outstrip bonds, it’s best to place all US stocks (and any remaining international stocks that didn’t “fit” into your brokerage account) into a Roth account. Why? Far in the future, you will need to withdraw from both traditional and Roth accounts. When you withdraw from a traditional account, you face income taxes, while distributions from Roth accounts are tax-free. Given that stock returns are, on average, higher, we should prioritize our most profitable assets in the account that will not generate future taxes.

             As an example, consider a person that consistently contributes $10,000/year to a US stocks and bonds.[i]  Specifically, they begin working at age 25 and retire at 65.  See below.

The person in the scenario is much better off allocating US stocks to the Roth account since, after forty years of employment, the value held in stocks is nearly four times that of the bond account. They would much rather draw the larger balance from the account that is tax free upon withdrawal—the Roth account!

Action 3:  Place your Bonds in Traditional Tax Shelters

             Finally, consider bonds. Profits on bonds are usually taxed as income, if held in a brokerage account. So, investors are typically wise to hold bonds in a tax shelter; however, as we learned above, bonds earn a lower average return and are generally unsuitable for Roth accounts. So, it’s typically best to hold bonds in a traditional tax shelter.  

***Disclaimer:  Admittedly, the decision of where to place bonds--and all assets, really--is complicated as it's driven by your (a) current tax brackets, (b) future tax brackets, and (c) interest earned on these accounts.  Note that (b) and (c) are values that are unknown at present.  Those in a high income tax bracket have the most to gain by holding bonds in a tax shelter.  Also, if stocks greatly outperform bonds, it's possible that avoiding taxes on stocks should be a higher priority.  What I have laid out above will work well for most, but may not be ideal for YOU.***

Action 4:  Fill-in the Gaps

             I’m concerned that some will read the above sections and build a portfolio that looks like this:

While each asset type is allocated to the tax efficient account, this person is unwisely prioritizing tax allocation treatment to decide what they are invested in. The tail is wagging the dog. As a rule, you should determine what you want to invest in first, then decide where those investments are held. Remember, we are trying to build a perfectly cromulent portfolio of assets and the asset mix above (which is bond-heavy and has more international stocks than US) certainly isn’t.

             Building a proper plan means there is money left over. For example, if you only desire to have $100,000 in bonds, but currently possess a traditional 457(b) with $250,000 in value, the remaining $150,000 will need to be filled with something. Likewise, you might desire to hold $400,000 in US stocks, but only have $250,000 in Roth IRA funding. Ultimately, a person in a scenario like these will need to invest $150,000 of their US stock holdings to their traditional accounts.  It’s also plausible that some investors, particularly those in their 20s, will not have all asset types. Perhaps you only have a brokerage account. If this is the case, you would, necessarily, need to include all assets in this one account. But, as you age, expect your investment portfolios to expand in scope and value so that more planning is required.

15.5.3:  Case Study

Oscar is 40 years old and decides to invest half his age in bonds—so 20% of his portfolio should be allocated to bonds. He decides to practice an 80%/20% split between US and international stocks; thus, 64% of his portfolio is held in US stocks and 16% is allocated to international stocks.[i] At present, he holds $240,000 in a brokerage account, $260,000 in a Roth 401(k), and $500,000 in a traditional 401(k). With a $1m portfolio, he should hold $200,000 in bonds, $640,000 in US stocks, and $160,000 in international stocks. Let’s build Oscar’s portfolio.

Action 1:  Place all international stock in brokerage accounts

• All $160,000 of international stocks is held in the brokerage account

• This leaves $80,000 in space remaining within the brokerage account

Action 2:  Place all US stock in Roth accounts

• The entire Roth 401(k) balance of $260,000 will be invested in US stocks

• This leaves $380,000 in US stock that needs a home

Action 3:  Place all bonds in traditional accounts.

• All $200,000 in bonds are held in the traditional 401(k)

• This leaves $300,000 in space remaining in the traditional 401(k)

Action 4:  Fill-in the Gaps

• Invest the unused $380,000 of US stock--$80,000 is held in the brokerage account and $300,000 in placed in the traditional 401(k)

The table below shows the final allocation. Because most US investors will hold a large share of US stocks, it is quite common for US stocks to be held in all three asset classes, just like Oscar.

Note:  In this case study, I’m assuming Oscar is building a million-dollar portfolio from scratch. That is not realistic. Instead, your portfolio will be amassed gradually and you should plan to craft a tax efficient plan from jump street. You’ll also need to rebalance from time to time to ensure that your portfolio doesn’t meander too far away from your desired allocations.

15.5.5 What about HSAs?

             As we have learned, HSAs are always traditional in nature (contributions avoid taxes) and often function as a Roth account as well (if funds are used to pay for medical expenses). As such, HSAs work well for just about any investment!  But, to be optimal, it’s often best to consider HSAs as your final allocation decision. Once you’ve completed steps 1, 2, and 3 of the recommend order of operations, you can then put whatever is left over in the HSA account and rest assured that this is a fine decision. Take a look at question 5 at the end of the chapter for an example.

 15.5.4 Conclusion

             The priority recommendations provided in this chapter will normally lead to a portfolio allocation that is optimal, or at least quite close. But, as your income and net worth rises, it’s plausible that you will need to reconsider your allocations—such cases are beyond the scope of this book (for now).

Practice Problems

1. Angela has $480,000 invested across three plans—a Roth IRA, and 401(a), and a brokerage account. Specifically, the Roth IRA holds $100,000 in value, the 401(a) has $210,000, and the brokerage account includes $170,000. She would like to invest $40,000 in bonds, $260,000 in US stocks, and $180,000 in international stocks. Build her a plan.

For this first question, I will provide a detailed explanation

Action 1:  Place all international stock in brokerage accounts

• The entire brokerage account balance of $170,000 will be invested in international stocks

• This leaves $10,000 in international stock that needs a home

Action 2:  Place all US stock in Roth accounts

• The entire $100,000 Roth IRA balance will be invested US stocks

• This leaves $160,000 in US stock that needs a home

Action 3:  Place all bonds in traditional accounts.

• All $40,000 in bonds are held in the 401(a), keeping in mind that 401(a) accounts are always traditional

• This leaves $170,000 in space remaining in the traditional 401(k)

Action 4:  Fill-in the Gaps

•  Invest the unused money. $10,000 in international stock and $160,000 in US stocks are necessarily held in the 401(a).

Here is the final allocation:

2. Phyllis has $100,000 invested across three plans—a Roth 401(k), a traditional 401(k) and a brokerage account. She would like to invest 70% in US stocks, 25% in international stocks, and 5% in bonds. Her Roth 401(k) has $12,000, her traditional 401(k) holds $20,000, and her brokerage account contains $68,000. Build her a plan.

Here is the final allocation:

3. Erin has $10,000 invested across three plans—a Roth 401(k), a traditional 401(k) and a Roth IRA. She would like to invest 75% in US stocks, 25% in international stocks, and 0% in bonds. Her Roth 401(k) has $6,000, her traditional 401(k) holds $3,000, and her Roth IRA contains $1,000. Build her a plan.

In this case, Erin has two Roth accounts. Note that accounts with the same tax treatment can be lumped together—it doesn’t matter if one is a 401(k) and the other is an IRA, they can be treated the same.

Here is the final allocation:

4. Creed has $2,000,000 invested in accounts. $1.5 million is held in a brokerage account, $300,000 is invested in a traditional 401(k), and $200,000 is held in a Roth IRA. He would like to invest 45% in US stocks, 15% in international stocks, and 40% in bonds. Build him a plan.

Here is the final allocation:

5. Toby has $100,000 invested in accounts. $40,000 is invested in a brokerage account, $30,000 is held in a traditional 457(b), $20,000 is invested in an HSA, and $10,000 is invested in a Roth IRA. He would like to invest 54% of his money in US stocks, 20% in international stocks, and 26% in bonds. Build him a plan.

Here is the final allocation:

End Notes

[1] Here is a good discussion for those that want to learn more:  https://www.bogleheads.org/forum/viewtopic.php?t=391956

[2] This is only true if your foreign taxes are $600 or less. If more, you will need to file a Form 1116 and the situation gets a lot more complicated. If you have $100,000 or less in international index stocks held in a brokerage account, it’s unlikely you will need to fill out a Form 1116.

[3] I assume a 10% annual return for stocks, 5% for bonds.

[4] Oscar holds 80% of the remaining 80% of his portfolio in bonds. (80%)*(80%) = 64%