Capital gains rates/ordinary income tax rates — By my calculations, this factor by far plays the biggest role. However, it is difficult to ascertain since we don’t know what future tax brackets will be. With financial planning software, you can project your future tax rate, but that will be based on today’s tax brackets. A new president and Congress in the future could have you in a much different situation. Generally speaking, though, if your combined tax bracket is greater than 25%, then stocks are best in the taxable account with bonds in the IRA. In other words, the traditional advice often works well in this situation. Word of caution: This completely depends on your stock and bond mix, which I’ll discuss in a moment.
Rate of return from dividends vs. rate of return from appreciation – If stocks didn’t pay dividends, then all of your return would be appreciation (assuming there is no turnover), which is tax deferred. However, many stocks do pay dividends, which causes taxation if held in a taxable account. The more of your return that comes from dividends, the more consideration should be given to the unconventional advice of placing stocks in the IRA and bonds in the taxable account. However, it still generally holds true that if your combined tax bracket is greater than 25%, then stocks are best in a taxable account with bonds in an IRA even if a large portion of the return comes from dividends. But like above, your stock and bond mix matters.
Portfolio turnover — This is how often the stocks in a portfolio are replaced every year. A very high turnover portfolio (i.e. 100%) would likely indicate that stocks are better off in an IRA account. This makes sense as stocks that are constantly sold would likely cause taxation, which you would want to defer. However, we cannot forget about the combined tax bracket. Are you seeing a theme here? If the combined tax bracket is greater than 25%, stocks are usually better off being placed in a taxable account with bonds in the IRA even if you have a high turnover portfolio. Also, I hate to sound like a broken record, but again the asset location decision also depends on your stock and bond mix.
Time horizon — The length of time you hold your investment will influence where stocks and bonds should be held. In almost all situations tested, the traditional advice of holding stocks in a taxable account and bonds in an IRA was best when time horizons were shorter than 20 years. However, once you exceed this time frame, the results were mixed depending on the various factors discussed in this article.
Stock vs. bond mix — if tax rates, as mentioned above, are the most important factor, then this is a close second. The amount of risk you are comfortable taking in a portfolio will definitely influence how to locate assets. One discernable pattern did stand out here when running through various scenarios. If you have a portfolio that is heavily weighted toward bonds (e.g. 20% stocks, 80% bonds), then usually it is better to follow the unconventional advice of placing stocks in an IRA and bonds in a taxable account. This was true regardless of tax bracket. Generally as the tax bracket increases above 25%, unconventional advice is best when the time horizon is shorter than 20 years, but traditional advice is best when time horizon was 20 years or longer.
As you can see, there is truly no one-size-fits-all approach. There are simply too many factors to consider to blindly just follow the traditional asset location advice of placing stocks in taxable accounts and bonds in IRAs. In many cases this does work out (especially if the combined tax bracket is greater than 25%); however, each client’s situation is unique and must be considered separately.