I've seen people suggest that fixed income should be in tax-deferred accounts like 401k and more tax efficient equities in taxable accounts. The logic is that you get to pay less taxes as you go along.
On the other hand, if you assume your equities rise faster than your fixed income investments, should not this extra growth be in tax-deferred accounts so that higher compound growth is happening inside the tax-deferred accounts? (Actually in example below the reason this approach wins is due to a bit more subtle issue discussed below.)
Since there are these two opposing forces, as you might imagine depending your assumptions you will get different results as to which way is actually better...
I put together a spreadsheet trying to evaluate both scenarios. I'll try to attach it but not sure if it will work as download. In any case here is an example. One thing I noticed in playing with the numbers in my spreadsheet, is that as soon as you start using even 1% or 2% tax (each year) on equities - it quickly becomes more important to hold them in tax-deferred account. Example below however shows that even with perfect 0% tax on equities during the holding period, sometimes it's better to hold them in tax-deferred account...
Initial assumptions (can be changed on spread-sheet):
equity growth rate (pre-tax) factor 1.08 (i.e. 8%)
fixed income growth rate (pre-tax) factor 1.04 (i.e. 4%)
number of years 20
marginal income tax 0.25 (i.e. 25%)
cap gains tax at the end 0.20 (i.e. 20%)
cap gains tax during period 0 (i.e. 0% - most tax efficient equity holding)
Thus...
after-tax cap gains growth rate factor 1.08 (same as above, since cap gains during 20-year holding period is 0%)
after-tax fixed growth rate 1.03 (4% after 25% tax)
Next, say you have $133,333 in 401(k) and 100,000 in taxable account and you are deciding which should go into which type of investment... Now, you might be wondering why I did not pick 100k in each, and it's very important! So, let me explain...
-------------------------------
Explanation:
The truth is I did at first start with 100k in each, but then looking closely at the results I noticed that just looking at fixed income part, it was better off outside of tax-deferred account than inside it. It did not make any sense until I realized my mistake. Since all of 401(k) is taxable at marginal rate in the end (including initial amount), the correct way of comparing is to consider 401(k) balance on after-tax basis (i.e. at 0.75*it's amount)...Thus, on after-tax basis, 401(k) is at 0.75*133,333=100k, same as taxable account.
Let me reiterate this important point - your after-tax dollar in taxable account has MORE real value than pre-tax dollar in tax-deferred account, since you paid taxes already on your taxable account dollar. So instead of deciding whether to place $1 in taxable account or $1 in tax-deferred, you have to compare investing $1 in taxable account vs $1.33 in tax-deferred one (assuming 25% tax rate)!
And here is another way of explaining... say you want to switch investments A and B in taxable vs tax-deferred account. To preserve your true asset allocation, if you switch $1 from A to B in taxable account, you have to switch $1.33 from B to A in tax-deferred account (under 25% tax assumption). And vice versa of course... switching $1 from A to B in tax-deferred account would need to correspond to a $0.75 switch from B to A in taxable account to preserve same asset allocation in real after-tax dollars.
-------------------------------
Now, let's do the comparison....
=================================================
Scenario 1: tax-defer fixed investments
After 20 years, you have...
tax-deferred fixed = 292,149 (which is 133k*1.04^20)
after taxes = above * 0.75 = 219,112
taxable equity = 466,096 (which is 100k * 1.08^20) Note: this is under best for this scenario assumption of 0% tax on equity - this 1.08 rate will be lower if you do pay any taxes for equity, i.e. it pays out any sort of dividends or distributes cap gains!!
after cap gain taxes = (above - initial 100k) * 0.8 + 100k = 392,877
Total after tax sum: $611,988
=================================================
Scenario 2: tax-defer equities
After 20 years, you have...
tax-deferred equity = 621,459 (which is 133k * 1.08^20)
after marginal 25% taxes you get above * 0.75 = 466,095
taxable fixed = 180,611 (which is 100k * 1.03^20) Note: 1.03 is the real after-tax rate you get under above assumptions (4% nominal at 25% tax rate)
after taxes it's the same amount, since it was already taxed along the way: 180,611
Total after tax sum for scenario 2: $646,706
=================================================
Did I get my math wrong anywhere?
If not, under above assumptions, it makes more sense to keep fixed investments in taxable accounts so that higher-growth equities grow tax-free (instead of first paying taxes on them to get them down from 133k to 100k and then have this smaller amount grow).
On the other hand, if you assume your equities rise faster than your fixed income investments, should not this extra growth be in tax-deferred accounts so that higher compound growth is happening inside the tax-deferred accounts? (Actually in example below the reason this approach wins is due to a bit more subtle issue discussed below.)
Since there are these two opposing forces, as you might imagine depending your assumptions you will get different results as to which way is actually better...
I put together a spreadsheet trying to evaluate both scenarios. I'll try to attach it but not sure if it will work as download. In any case here is an example. One thing I noticed in playing with the numbers in my spreadsheet, is that as soon as you start using even 1% or 2% tax (each year) on equities - it quickly becomes more important to hold them in tax-deferred account. Example below however shows that even with perfect 0% tax on equities during the holding period, sometimes it's better to hold them in tax-deferred account...
Initial assumptions (can be changed on spread-sheet):
equity growth rate (pre-tax) factor 1.08 (i.e. 8%)
fixed income growth rate (pre-tax) factor 1.04 (i.e. 4%)
number of years 20
marginal income tax 0.25 (i.e. 25%)
cap gains tax at the end 0.20 (i.e. 20%)
cap gains tax during period 0 (i.e. 0% - most tax efficient equity holding)
Thus...
after-tax cap gains growth rate factor 1.08 (same as above, since cap gains during 20-year holding period is 0%)
after-tax fixed growth rate 1.03 (4% after 25% tax)
Next, say you have $133,333 in 401(k) and 100,000 in taxable account and you are deciding which should go into which type of investment... Now, you might be wondering why I did not pick 100k in each, and it's very important! So, let me explain...
-------------------------------
Explanation:
The truth is I did at first start with 100k in each, but then looking closely at the results I noticed that just looking at fixed income part, it was better off outside of tax-deferred account than inside it. It did not make any sense until I realized my mistake. Since all of 401(k) is taxable at marginal rate in the end (including initial amount), the correct way of comparing is to consider 401(k) balance on after-tax basis (i.e. at 0.75*it's amount)...Thus, on after-tax basis, 401(k) is at 0.75*133,333=100k, same as taxable account.
Let me reiterate this important point - your after-tax dollar in taxable account has MORE real value than pre-tax dollar in tax-deferred account, since you paid taxes already on your taxable account dollar. So instead of deciding whether to place $1 in taxable account or $1 in tax-deferred, you have to compare investing $1 in taxable account vs $1.33 in tax-deferred one (assuming 25% tax rate)!
And here is another way of explaining... say you want to switch investments A and B in taxable vs tax-deferred account. To preserve your true asset allocation, if you switch $1 from A to B in taxable account, you have to switch $1.33 from B to A in tax-deferred account (under 25% tax assumption). And vice versa of course... switching $1 from A to B in tax-deferred account would need to correspond to a $0.75 switch from B to A in taxable account to preserve same asset allocation in real after-tax dollars.
-------------------------------
Now, let's do the comparison....
=================================================
Scenario 1: tax-defer fixed investments
After 20 years, you have...
tax-deferred fixed = 292,149 (which is 133k*1.04^20)
after taxes = above * 0.75 = 219,112
taxable equity = 466,096 (which is 100k * 1.08^20) Note: this is under best for this scenario assumption of 0% tax on equity - this 1.08 rate will be lower if you do pay any taxes for equity, i.e. it pays out any sort of dividends or distributes cap gains!!
after cap gain taxes = (above - initial 100k) * 0.8 + 100k = 392,877
Total after tax sum: $611,988
=================================================
Scenario 2: tax-defer equities
After 20 years, you have...
tax-deferred equity = 621,459 (which is 133k * 1.08^20)
after marginal 25% taxes you get above * 0.75 = 466,095
taxable fixed = 180,611 (which is 100k * 1.03^20) Note: 1.03 is the real after-tax rate you get under above assumptions (4% nominal at 25% tax rate)
after taxes it's the same amount, since it was already taxed along the way: 180,611
Total after tax sum for scenario 2: $646,706
=================================================
Did I get my math wrong anywhere?
If not, under above assumptions, it makes more sense to keep fixed investments in taxable accounts so that higher-growth equities grow tax-free (instead of first paying taxes on them to get them down from 133k to 100k and then have this smaller amount grow).