Indexfundfan\’s blog (new URL is Indextown.com)

September 8, 2006

Tax efficient placement of investment assets

Filed under: Investing — indexfundfan @ 12:03 am

Larry posted (52528) the link to an article by the TIAA-CREF Institute on the tax efficient placement of investment assets. The paper is titled “Maximizing Long-Term Wealth Accumulation”. The paper discusses “the advantages of placing equities in taxable accounts and taxable bonds in tax-deferred acounts in order to maxmize tax efficiency.”

The idea of placing equities in taxable accounts and bonds in tax-deferred accounts is not new. The reason for this recommendation is due to the differential tax treatment of capital gains and interest income. In a taxable account, capital gains (long term) are taxed at a maximum of 15% while interest income are taxed at the income tax rate of up to 35%.

Now consider the fact that tax-deferred accounts are always taxed at the income tax rate of up to 35% at withdrawal, regardless of whether the gains come from capital gains or interest income. What this means is that if we keep equities in the tax-deferred account, the more valuable capital gains rate actually gets “converted” into income tax rate, an undesirable situation. On the other hand, there is no such disadvantage if bonds are kept in the tax-deferred account since interest income is taxed at income tax rate anyway. Therefore, bonds are ideally placed in the tax-deferred account and equities in the taxable account.

Placing equities in the taxable account also has some other benefits, like ability to perform tax-loss harvesting, foreign tax credit, and the eventual stepped-up basis for the heirs

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