What Should <i>Not</i> Be In Your Retirement Plan

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 15, 2005

IN THIS ISSUE:

1. “Tax Efficiency” In Your Investments

2. Stocks & Bonds – Where To Hold Them

3. Active Versus Passive Management

4. Limited Investment Choices In Most 401(k)s

5. Take Advantage Of Employer Matching Contributions

6. Betting On Future Tax Rates

Introduction

Over the years, there have been numerous articles written about why many workers do not choose to participate in their employers’ 401(k) plans, why others who do participate do not contribute the maximum to these retirement plans, and why many do not invest their contributions effectively. The same goes for IRAs and other retirement plans.

Maximizing our retirement savings is crucial to all of us, including those already in retirement, so I encourage you to read this E-Letter in its entirety. Below you will find some valuable information that is not often written about.

One subject that is often overlooked when discussing 401(k) plans and other retirement plans is how tax-deferred money is invested in relation to other taxable investments held by the plan participant. This week, I want to give you some basic guidelines on what you should hold in your 401(k), or other tax-deferred accounts, and what should be held in taxable accounts. This subject is often quite confusing.

There are individuals who have been quite successful in saving and investing both inside and outside of their 401(k) plans, and you should be one of them. In order to do so, you need to consider how various tax laws relate to specific investments, and how these tax issues can make a difference in the ability of various asset classes to meet the retirement goals of the individual.

As one example, there has long been a spirited debate about whether you should hold stocks, which have the benefit of the lower capital gains tax rate, in your 401(k), or whether you should hold mostly bonds, which don’t have the tax advantage, in your tax-deferred retirement account. It’s an interesting and complicated issue.

A recent article in the Journal Of Financial Planningdealt extensively with this subject. This magazine is the flagship publication of the Financial Planning Association, and is geared toward investment professionals. As a result, the articles can often be too “nerdy” to attract the interest of most investors.

However, because I feel the proper placement of investments is an important issue, in this week’s E-Letter I’m going to discuss some factors that should be considered when you are seeking to invest taxable money versus that held within tax-deferred accounts such as your 401(k) or your IRA. The discussion below will include many of the issues discussed in the Journal article, and I will also include a number of observations from my 30 years in the business.

One last note before we jump in: Much of the discussion that follows has to do with taxes and tax efficiency when it comes to investments. Keep in mind that I am NOT a CPA or other tax professional. While the discussion below represents my best understanding based on the research I have performed, it should not take the place of counsel from a qualified tax professional. My hope is that this article will supply you with the appropriate questions to ask when considering whether to place certain investments inside or outside of a 401(k) plan or a traditional IRA (not Roth IRAs).

“Tax-Efficiency” In Your Investments

As you are probably already aware, one of the big subjects in relation to investment management is the idea of “tax efficiency” – how to invest so that you pay the least amount of income taxes. After all, who wants to give the government more of their savings than what is absolutely necessary? However, there is always the issue of balancing tax efficiency with growth potential. You can minimize taxes by keeping your money in a non-interest-bearing checking account, but that wouldn’t be very wise. The trick is to maximize the growth of your investment portfolio while at the same time taking advantage of tax efficiency whenever possible.

You may also be wondering why I am bringing up this subject in relation to retirement plan assets, since taxes on any gains within qualified retirement plans are deferred until the money is actually withdrawn, presumably at retirement. The reason is that, while there are some investments that should not go into a tax-deferred account, such as municipal bonds, collectibles, etc., little attention has been paid to the proper placement of mainstream investments such as stocks and bonds.

In light of recent tax law changes, it can make a big difference as to what type of assets you place within your retirement plan, versus holding them in outside taxable accounts. To facilitate your understanding of this, it’s important to know what happens to investment gains that are generated in a retirement plan.

By law, any money that comes out of a retirement plan is considered to be “ ordinary income” which is taxed at the applicable IRS tax rate for such income. Thus, even though gains may be in the form of interest, dividends, short-term and long-term capital gains, etc., it is ALL treated as ordinary income once you start withdrawals at retirement. This is why you would not put municipal bonds in a 401(k) or an IRA, since doing so would convert tax-free interest earnings into taxable gains.

The conventional wisdom regarding retirement plan distributions was always that taxes would be deferred until you retired, at which time you would likely be in a lower tax bracket. Since tax rates were pretty much uniform for various types of income, it was unnecessary to consider where assets should be located for the greatest tax efficiency.

This was generally true until Congress passed tax reform legislation in 2001 and 2003. Now, the tax rate for both long-term capital gains and dividend income has been reduced to 15%. While the maximum tax rates for ordinary income were also reduced, these reductions were nowhere near the reduction to 15% for capital gains and dividend income.

A number of studies have been performed and papers written regarding the optimum allocation of investments between taxable and tax-deferred accounts for maximum tax efficiency. As a general rule, these studies have shown that stocks (including equity mutual funds) should be held outside of an IRA or 401(k), while bonds should be held inside. However, if that were the entire story, not only would other important factors be omitted, but this would be my shortest E-Letter on record.

There’s No Single Solution For All Investors

Over the course of my career in the financial services industry, I have found that the most appropriate answer to most initial questions about retirement plans is, “It depends.” That’s because the whole subject of retirement plans is so large and complex, it is very difficult to come up with absolute statements regarding any given question.

For example, financial literature and well-meaning financial planners will always tell you that investors should never put an annuity inside an IRA or 401(k). Most financial planners will say, “Never place a tax shelter within a tax shelter.”

Well, that’s correct if it is a true shelter you’re talking about. As I discussed above, you generally would not place municipal bonds in a retirement account, since it would convert earnings that were once sheltered from tax into taxable ordinary income. Earnings within an annuity, however, are not truly sheltered; taxation is simply deferred until a later time.

When I am asked about whether to retain an existing annuity in a retirement account, my answer is that it depends upon a number of factors that must be investigated. For example, some financial planners would advise a client to liquidate an annuity that was held in a tax-deferred account; however, this could subject the client to large surrender charges, and possibly not be in his or her best financial interest.

The bottom line is that it is very difficult to make absolute statements on most any matter regarding retirement plan assets. Thus, it is no surprise to me that the question of whether stocks should be placed inside or outside of a retirement plan really depends upon a number of factors, which we will discuss as we go on.

Stocks & Bonds – Where To Hold Them

In most cases, taxable bonds should be placed inside retirement accounts whenever possible, since periodic interest gains are considered ordinary income for tax purposes. By the same token, if a stock is bought and held until retirement, it would likely be best placed outside of the retirement account. That way, any capital gains would be long-term in nature, and would enjoy the 15% tax rate. Any dividends along the way would also enjoy the low 15% tax rate.

However, many stocks are not bought and held until retirement. Instead, investors typically buy and sell stocks as they gain and lose favor over time. I’m sure all of us are familiar with the phone call from the broker announcing that ABC’s common stock has hit the firm’s price target, so it’s time to take your profits and move to XYZ company stock. Depending upon the holding period of the ABC stock, there may be little or no tax benefit to holding it outside of the retirement account.

If the stock generates a loss, however, it may be more beneficial outside of the retirement account. The reason for this is that losses within a retirement account simply reduce the amount of assets in the plan, but do not offset gains from other assets. Outside of the retirement plan, capital losses can be used in certain circumstances to offset capital gains from the sale of other assets. This can be very important from a tax efficiency standpoint.

Active Versus Passive Management

The proper placement of equities also depends upon whether the investment is actively or passively managed. This is especially true in relation to investments in equity index mutual funds. These funds, along with specialized Exchange Trade Funds (ETFs), are proliferating in the market today, and offer investors a low-cost way to emulate the performance of a specific stock or bond index in a very tax-efficient manner.

If equity holdings are in the form of index mutual funds or ETFs that are going to be held long-term, then it is usually more efficient to hold them outside of a retirement account. Of course, tax efficiency is just one factor to consider when investing in these instruments. Since they are tied directly to a stock market index, the volatility can be significant, no matter which particular index is chosen.

Studies on tax efficiency have shown that actively managed equity portfolios may be better off if placed inside a retirement plan than if held outside in a taxable account. The reason for this is that actively managed strategies tend to trade more frequently, many times after holding a particular stock for less than one year. In such cases where the gains are short-term in nature, it can be beneficial to place them in the retirement plan. This applies to most of the active management programs I recommend.

Note that this is true even if the investment being actively traded is an equity index mutual fund or ETF. The reason for this is that rather than holding the index fund long-term to generate gains, it is traded somewhat frequently in an attempt to generate short-term capital gains, which are taxed as ordinary income.

When discussing active management strategies, I include programs in which securities are bought and sold based on fundamental analysis, traditional market timing, sector rotation, long/short, etc. For a full discussion of the various active management strategies, see my latest Special Report on ABSOLUTE RETURNS.

Due to the frequency of trading in many actively managed programs, long-term capital gains are not anticipated. Because most active strategies result in short-term gains, they are best held in tax-deferred retirement accounts whenever possible.

Other Important Factors To Consider

There are a number of additional factors to consider when determining the best location for various types of investments. One important factor is the need for current income. There are a number of investors who have a simultaneous current need for income as well as future growth.

I mentioned above that taxable bonds are usually best held in retirement accounts due to the ordinary income nature of interest earnings. However, dividend yields on stocks today may not be sufficient to fund income needs. In such cases, it may be necessary to have some bond holdings outside of the retirement account to provide sufficient income. This would prevent having to withdraw money from the retirement account and possibly triggering the 10% penalty tax on withdrawals prior to age 59½.

The same holds true for actively managed equity programs. For more tax efficiency, usually best to hold actively managed investments within a tax-deferred retirement plan if possible. However, there can be reasons to hold a portion of your actively managed investments outside of your retirement plan. For example, an investor may want to accumulate the funds necessary to start his/her own business. Equities would probably be advisable to provide the growth potential, but the investor would not want to raid the retirement account and pay the penalty to get to these funds.

Limited Investment Choices In Most 401(k)s

Another issue that might affect an investor’s ability to allocate investments for maximum tax efficiency is the selection of “allowable” investments within a 401(k) plan. In general, 401(k) plans are very beneficial in that they usually put the participant in control of the investment decisions. Unfortunately, many 401(k) plans do not offer a wide variety of investments from which to choose. In such cases, selecting the most tax efficient options may be difficult, if not impossible.

If you participate in a 401(k) plan that offers few choices, you may be forced to maintain passive, buy-and-hold equity positions within your retirement account. If you find yourself in such a situation, you might share this article with your employer. If given a good reason, many employers will expand the investment choices.

If you are concerned about tax efficiency, it’s pretty likely that the owner of your company should be concerned about the same thing, possibly even more so. (Rather than annoying your employer, the boss might actually appreciate having the benefit of this information, and be more likely to make additional choices available in the plan.)

A final thought about tax efficiency pertains to the tax treatment of the 401(k) contributions made by the employee, and the availability of “ employer matching contributions,” which I will discuss further below. While it may be true that a lump sum invested in stocks or equity mutual funds at any given point in time may be more tax efficient outside of a retirement account, the tax treatment of monthly plan contributions may serve to offset this tax advantage.

For example, most 401(k) plans employ what is known as “dollar cost averaging.” This means that contributions are made from an employee’s compensation on a monthly or bi-monthly basis, with each contribution buying a different number of shares of the various investment options, based on the price at the time of the contribution. Because these contributions are made to a tax-qualified retirement plan, they are made on a pre-tax basis, meaning no income tax is withheld prior to the contribution being made.

Over the working lifetime of the employee, the pre-tax contributions, plus employer matching contributions, grow at the same rate they would if they had been purchased outside of the plan, but the number of shares subject to the growth is roughly double that of the taxable account.

Take Full Advantage Of Employer Matching Contributions

As noted above, many companies offer “matching contributions” in their retirement plans that you should ALWAYS take full advantage of, if at all possible. These employers match a portion of what the employee contributes each year. (At my company, for example, we match 50% of what our employees contribute, up to the legal limit.)

These matching contributions effectively provide an “instant return” on the employees’ savings, but are not currently taxed to the employees. If the employer matches 50% of employee contributions, for every $10 the employee contributes, $15 goes to buy investments in the retirement account. An instant 50% return!

In contrast, investments bought in a taxable account are made “after-tax,” meaning that the employee must first have income taxes withheld from the purchase amount. Thus, for an employee in the 25% income tax bracket, the same $10 would buy only $7.50 of the investment, or half of what is purchased in the 401(k) plan.

This is why you should ALWAYS take full advantage of all employer-matching contributions!! Interestingly, it is often the younger employees that don’t take advantage of this, even though – because of their age – they have the most to gain from it.

Betting On Future Tax Rates

Perhaps the biggest issue facing you as you try to determine the best placement of your investments is the uncertainty of the tax laws. I can remember a time when the maximum incremental tax rate was 70%. No doubt some of you can also remember those “bad old days.” Since then, tax rates were slashed in 1986, and then again in 2001 and 2003. My personal opinion is that tax rates are now probably as low as we will ever see them.

With increasing federal budget deficits and a huge future shortfall in both Social Security and Medicare, I don’t see anywhere for tax rates to go but up. In addition, if the Democrats are successful in taking the White House and/or both houses of Congress, you can guess where they will turn their gaze when seeking additional tax revenues.

Since liberals see capital gains and dividends as primarily enjoyed by the “rich,” it is very likely that future legislation will increase the tax rates applying to these sources of income. However, if budget deficits continue into the future, it is not inconceivable that a bipartisan effort to increase tax rates may be undertaken.

That being the case, it may be futile to try to plan for tax efficiency using tax rates that could end-up being moving targets. For this reason, I always suggest that my clients review the allocation of their investments – both taxable and tax-deferred - each time major tax legislation is passed. Things change and thus our tax strategies must change with them.

Conclusions

Allocating your investments among taxable accounts and tax-deferred retirement plans such as IRAs and 401(k)s is an important part of planning for your financial future. Unfortunately, there is no “ one-size-fits-all” strategy that will apply to every individual. The appropriate location for various types of investments depends upon your own unique goals and financial situation.

As a result, I think it is important to consult with a qualified tax professional before making decisions as to where to place various investment opportunities. However you decide to allocate your assets, it is important that you maintain a “big-picture” view of your overall portfolio.

Many investors allocate their investment portfolios among a variety of asset classes, but often lose sight of the overall rationale directing the placement of assets among various types of accounts. For example, if we follow the simple rule of thumb and place bonds in a retirement account and keep index funds in taxable accounts, there will no-doubt be times when stocks are doing well and bonds are suffering, and vice versa.

Investors must resist the temptation to evaluate their retirement plan assets by comparing them to their taxable accounts. Doing so can lead to frequent reallocations based on chasing performance, and not on proper diversification. In a big-picture performance review, it is important to consider how the portfolio is structured to meet future goals without regard as to how different accounts are faring in relation to one another.

If you are concerned about the way your investment portfolio is structured, or if you are not sure about the tax efficiency of your various investments, we will be glad to help you analyze your situation at no charge.

I have four professional Investment Representatives on my staff (five, if you include me) that are dedicated to helping our clients and prospective clients in structuring their investment portfolios. The Investment Representatives are all salaried employees (no commissions), very professional and very friendly to deal with – no pressure ever.

Typically, we start with a detailed evaluation of the prospective client’s current investments. Every prospective client is different, so our advice is tailored to fit each investor’s goals and risk tolerance. We use sophisticated investment planning software, along with our financial planning experience in making our recommendations.

We can help you determine, not only what investments make sense for you, but also which of your investments may be better suited in taxable versus tax-deferred accounts.

Just give one of our Investor Representatives a call at 800-348-3601, or e-mail us at mail@profutures.com .

Best regards,

Gary D. Halbert

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