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Planning tax efficiency in investing

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Planning tax efficiency in investing

Ask Dr. Don by Don Taylor, Ph.D., CFA • Bankrate.com

Dear Dr. Don,

I had a question on asset allocation. My present age is around 30, I maxed out my retirement investing through 401(k)s and Roth IRAs. The remainder of my savings is invested in a taxable mutual fund account. Given my age, almost all retirement funds are in equities since these funds can bear the risk of stock-market volatility over 30 years.

The taxable funds have a more balanced asset allocation of 80:20, equity/bonds, since the timeline of this investment is about five years. Most of the bond funds are TIPS and Massachusetts municipal bonds. Almost all asset allocation articles recommend moving such types of investment into a tax-free or tax-delayed account. How does a young investor balance taxable investments in a tax efficient manner?

-- Boston Beanie

Dear Beanie,

Tax efficiency is an important part of investing and not just in taxable accounts. Keeping in mind how distributions out of tax-advantaged accounts will be taxed is also an important part of investing. The pretax dollars that you invested in your 401(k) plan(s) will be taxed as ordinary income when they are withdrawn from the account as qualified distributions.

Treasury Inflation Protected Securities, or TIPS, are usually recommended for tax-advantaged accounts because the inflation adjustments are treated as taxable income each year, but you don't receive that income until you sell the security. While you can look at holding TIPS in a taxable account as a method of forced savings by paying the taxes now so you don't have to pay the taxes at redemption, investors tend to chafe at this pay-as-you-go approach.

TIPS held in mutual funds have this same tax issue. Municipal bonds or municipal bond funds don't belong in a tax advantaged account because the tax advantage is inherent in the investment. Although they're not widely available, corporations and municipalities will occasionally offer inflation-indexed securities.

With long-term capital gains and dividend income currently taxed at 15 percent less if you're in the lower marginal tax brackets, there are a lot of ways to manage your tax exposure in a taxable account. Mutual funds don't give you that flexibility because they have to pass through their gains and losses to investors. The tax efficiency of the mutual fund depends on the mutual fund manager's investment decisions and the investment policy of the fund. Actively managed mutual funds will be less tax-efficient than most index funds. Morningstar, among others, provides tax efficiency ratings for mutual funds.

Depending on how you invest, exchange-traded funds could provide greater efficiency at lower cost than equity mutual funds in managing your tax exposure between now and retirement. The Bankrate feature, "Exchange-traded funds may help you sleep at night," has more on using ETFs.

If you truly have a five-year horizon on the investments in your taxable accounts, then I would say that your 80/20 split between stocks and bonds is a bit aggressive. You can get over 4 percent in cash, and short-term doesn't look all that good for bond prices. You didn't mention what portion of your portfolio was invested overseas, but that should be a consideration in your asset allocation as well.

You've got enough going on in your investments that it would be worth your while to meet with a financial planner and talk through some of these issues. I'd recommend a fee-only planner to provide a consult on these issues. It will be money well-spent.

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