Sunday, July 29, 2012

Stock vs Bonds, tax comparison, Summary

This is the summary table.
Stock, Bond ST capital gainStock, Bond LT capital gainStock qualificed DividendStock non-qualified DividendTax-exempt bond interestTaxable bond interest
Tax rate28%15%15%28%0%28%

Now let's get familiar with the concept of asset location. Many of you might have heard of the term asset allocation, which we will discuss in the future posts, but asset location is a quite different beast that is still important for a successful investor.

If every other investment decision remains the same, a good asset location will maximize after tax investment return. Note, we always talk about after-tax return, not the actual amount of taxation. It does not matter how much Uncle Sam charges you, as long as we end up with more money in the pocket, that asset location is a successful one.

Personally, I employ this strategy for when it comes to asset location:

Maximize tax-free and tax-deferred (401k and IRA, maybe 529 as well) accounts with investments with the following priority
  1. Taxable bonds. These bonds are guaranteed to generate realized interest gains every year that are taxed at a hefty 28%.
  2. Actively managed stock funds. Actively managed funds tend to have high turn-over, which means that they may incur a lot of realized capital gains at 28%. 
  3. Foreign stocks. Foreign stocks are taxed heavily on their dividends at 28%.
The location of other types of investment does not matter too much if you are a buy-and-hold investor. If you often trade, then it makes sense to treat them the same way as actively managed stock funds with high turn-over.

So the idea is pretty simple, put the tax-efficient investments in your normal accounts and put those less tax-efficient into tax-advantaged accounts. 

At the end of this rather short post, I want to stress again, always aim for maximizing AFTER-TAX RETURN instead of minimizing tax. A lot of people have fallen to the trap of omg-I-don't-want-to-pay-tax.

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