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Asset Location for Tax-Efficiency March 26, 2007

Posted by pf in Portfolio Allocation, Taxes.

One aspect of my portfolio allocation that I had not considered was how to allocate my investments in the most tax advantaged way.  Typically, someone would need to locate their assets among the following:

Tax Advantaged Accounts: Traditional IRA, Roth IRA, etc.
Taxable Accounts: Brokerage, etc. 

Why does tax efficiency matter?  Although your Traditional and Roth IRAs are tax-advantaged, you can not avoid taxes – only delay them.  Essentially, you can “pay now” with a Roth IRA or “pay later”  with a Traditional IRA.   Similarly, your investments in these accounts are not all created equal from a tax perspective.  Your mutual funds can differ significantly in their tax-efficiency and depending upon the vehicle they are invested in, can have an impact on how much of your investment you get to keep in retirement.

As my goal has always been to max out my Roth and Traditional IRAs first, I don’t really have any significant taxable investments except for liquid cash. As such, for my immediate purposes, I am not going to give any considerations to my “taxable accounts”, but rather focus on my primary investment vehicles which are my Traditional and Roth IRAs.

As I conducted research on the topic, there were some articles / information that I thought were useful: 

MorningstarAsset Classes in Rollover IRA vs Roth IRA

Schwab – “Tax-Efficient Investing is More Important Than Ever

Morningstar –  “The Best Investments for Tax Deferred Accounts” & “The Best Investments for Your IRA

MyMoneyBlog – “Tax Efficient Mutual Fund Placement for Maximm Return

Interestingly, the majority of research I could find focused on tax-efficiency in taxable versus non-taxable accounts.  I found very little in terms of Roth vs Traditional IRA only.  

Generally speaking, much like the decision you face with deciding between a Roth and Traditional IRA account, there are a number of assumptions that can drive your decision making, such as:

- How many years until I retire?
- What will my tax bracket be higher or lower during retirement?
- What will tax rates be in the future?

Additionally, you must also consider what returns you can expect from the various investment classes (ex: stocks vs. bonds).

Obviously, this is extremely difficult (if not just impossible)…but not really any different than any of our other investment decisions where we are trying to plan for the future.  Therefore, I will make some assumptions based upon what I believe to be my future:

- How many years until I retire?  28 – just as I have used in my previous retirement calculations
- What will my tax bracket be higher or lower during retirement?  I think for the overwhelming majority of the population it is lower…I hope for higher, but will go with lower.
- What will tax rates be in the future?  Taxes are the lowest they have been in decades…I think higher taxes are inevitable.
- What will my investments returns be in the future? I have always been a bit conservative here and expect 8% on stocks pre-retirement and 6% post. For bonds, I will assume 4%.

Based upon these assumptions and using a typical Roth vs IRA calculator like this one, I see a clear advantage to the Roth vs Traditional IRA in terms of where I get the most after-tax return for my investment. 

Therefore, based upon some of the research above, I am led to believe the best course of action is to allocate the mutual funds where I can expect the most return and that are the least tax-efficient to my Roth IRA.

I utilized the premium mutual fund screener from Morningstar to get the cost tax ratio and historical returns for the funds I’m currently invested in:


Fund 3-year Tax Cost Ratio (%) 5-year Tax Cost Ratio (%) 10-year Tax Cost Ratio (%) 3-year Return (%) 5-year Return (%)
PREMX 2.76 2.70 3.47 13.80 14.59
PRHYX 2.61 2.81 3.23 8.14 9.68
PRWCX 1.26 1.08 2.07 11.89 10.96
PRFDX 1.19 1.10 1.76 12.42 8.35
PRGFX 0.25 0.18 1.51 10.23 6.49
TRMCX 1.66 1.22 1.39 15.90 13.59
PRSVX 0.77 0.62 1.15 16.34 14.95
RPMGX 0.79 0.47 0.59 13.63 9.98
PRMSX 0.79 0.53 0.32 28.48 24.33
PIEQX 0.62 0.59 - 19.65 14.82

Those funds with the lowest tax cost ratio are more tax efficient than those with a higher cost tax ratio.  Not surprisingly, bonds have the highest cost tax ratio among the various funds.  However, we are also looking for those with the expected highest returns in the future.   Of course, future returns are anyone’s guess, but I do like to use long term historical returns as a benchmark. 

What becomes very difficult is finding the correct weighting between the two criteria.  For example, PRMSX has created a markedly better return while PREMX has generated a lesser return, but is much more tax-INEFFICIENT.   Further, do I really believe that these bonds will sustain these types of returns?  

Ultimately, I think I should weight more heavily toward the investments that I think will deliver the greatest returns over time.  The fact you will never pay taxes on your Roth dictates that you create the most wealth in that vehicle (versus your traditional IRA which will be taxed later).  The tax efficiency then plays a secondary role among similar investments who meet the first criteria. 

As a result, I might rank the funds as follows:


Fund Fund Type 3-year Tax Cost Ratio (%) 5-year Tax Cost Ratio (%) 10-year Tax Cost Ratio (%) 3-year Return (%) 5-year Return (%)
TRMCX Mid-Value 1.66 1.22 1.39 15.9 13.59
PRSVX Small-Value 0.77 0.62 1.15 16.34 14.95
PREMX Emerging-Bond 2.76 2.7 3.47 13.8 14.59
PRWCX Moderate Allocation 1.26 1.08 2.07 11.89 10.96
PRMSX Intl – Emerging 0.79 0.53 0.32 28.48 24.33
PIEQX Int; – Europe 0.62 0.59 - 19.65 14.82
PRFDX Large-Value 1.19 1.1 1.76 12.42 8.35
PRGFX Large- Growth 0.25 0.18 1.51 10.23 6.49
RPMGX Mid-Growth 0.79 0.47 0.59 13.63 9.98
PRHYX High Yield Bond 2.61 2.81 3.23 8.14 9.68

Unfortunately, even this ranking does not seem obvious to me.  For example, I struggle with PRMSX (emerging markets) as I tend to believe the returns we have received in the last 5 years or so must moderate (this part of the world is no longer a secret) and it is highly tax efficient.  I would really like to take a definitive position here, but I’m still not sure I have enough information / knowledge yet to do so. 

Ultimately, I will make a choice, but would greatly appreciate feedback from anyone else who has considered this.




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1. dave neal - April 25, 2007

last year i went through a process of revising my asset allocation. at that point, i did not try too hard to optimize the placement in Roth vs. regular IRA. so i have some of all asset classes in both Roth and regular IRA. the reason for broadly diversified asset allocation is exactly because you cannot forsee which asset classes will outperform in the short term. so, i plan to use “reversion to the mean” and rebalancing to drive my asset location. here is what i mean: each year i will convert a portion of my IRA to my Roth IRA. i will do that by selling asset classes that are over my target % in the IRA and buying asset classes that are under my target % in the Roth. over time, this strategy should tend to put assets that are undervalued in the Roth, where they should produce above average returns. this strategy has not been tested or written up academically, as far as i know.

2. pf - April 25, 2007

Interesting approach. I think you are suggesting that we are after the same thing (putting the highest returning assets) in the Roth, but are providing a different method for going about it. I will definitely give it some thought.

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