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Author: warrl Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5069  
Subject: Re: what to buy where Date: 12/4/2003 4:19 PM
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The answer relates to tax rates on the basic sort of income, versus tax rates on withdrawals.

NOTE: I am considering ONLY FEDERAL taxes. You get to factor in your state taxes. I *think* the top tax rates are 15% on long-term gains and qualifying dividends, 0% on tax-exempt bonds, and 30% on everything else. I'm arbitrarily giving a 5-point benefit on tax rates for any sort of tax deferral, but not reducing effective rates below 0. I'm ignoring any number of complicating factors in the tax laws, such as AMT.

Effective tax on kind of income:
* Interest on tax-exempt bonds: 0%
* Long-term gains: 10%
* Qualifying long-term dividends: 15%
* Interest on tax-deferred bonds: 25%
* Other income - rent, short-term gains & other dividends, other interest, miscellaneous: 30%.

Tax on withdrawals:
* Roth: 0%, overriding tax on kind of income.
* Conventional IRA (except basis), 401K: 25%, overriding tax on kind of income. However the tax deferral until WITHDRAWAL provides an additional benefit. Let's call the result 25%.
* Taxable: see tax on kind of income (and it's taxed as realized, not on withdrawal)

By definition, the taxable account provides 0% tax benefit on each kind of income.

The other two types of account provide benefits as follows:

* Roth IRA: forces effective tax rate to 0.
Tax-exempt interest: 0 benefit
Long-term gains: 10% benefit
Qualifying dividends: 15% benefit
Tax-deferred interest: 25% benefit
Other income: 30% benefit

401K (and conventional IRA): forces effective tax rate to 25%
Tax-exempt interest: NEGATIVE 25% benefit
Long-term gains: NEGATIVE 15% benefit
Qualifying dividends: NEGATIVE 10% benefit
Tax-deferred interest: 0 benefit
Other income: 5% benefit

Sort them in order by (1) effective tax rate ascending, (2) tax benefit descending.

Roth, other income (0%, 30%)
Roth, tax-deferred interest (0%, 25%)
Roth, qualifying dividends (0%, 15%)
Roth, long-term gains (0%, 10%)
Roth, tax-exempt interest (0%, 0%)
Taxable, tax-exempt interest: (0%, 0%)
Taxable, long-term gains (10%, 0%)
Taxable, qualifying dividends (15%, 0%)
401K, other income (25%, 5%)
401K, tax-deferred interest (25%, 0%)
Taxable, tax-deferred interest (25%, 0%)
401K, qualifying dividends (25%, -10%)
401K, long-term gains (25%, -15%)
401K, tax-exempt interest (25%, -25%)
Taxable, other income (30%, 0)

This is the order of preference, from top to bottom.

Now if two investments are expected to produce the same sort of income, do the one that has the higher rate of return first.

If one investment will produce two kinds of income, you can either decide relative proportions and treat it as a special kind of security with a prorated effective tax rate, or pick the dominant sort of income and forget the other one.

For example, if you decide that your investment in a rental property will return profits 50% in the form of long-term gains and 50% in the form of rent, that makes it a special sort of investment with an effective tax rate of 20% (50% of the 10% effective tax on long-term gains, plus 50% of the 30% tax on rent).

Roth, rental house (0, 20%)
Taxable, rental house (20%, 0)
401K, rental house (25%, -5)

You can sort these into the list yourself.

On the other hand, if you are confident that you can buy 20-year bonds this year at 6% yield to maturity and sell them in 15 months at 4% yield to maturity (wouldn't that be nice!), virtually all your expected income from this investment is long-term gains. You can safely ignore the dribble of interest. (If interest rates rise to 8% - oops! Then you either take a loss, or let the interest income dominate and study how to cheaply get your investments into better alignment with the priority list.)

Note, you won't necessarily invest in exactly that order, for practical reasons. For example, buying a house inside a Roth is tricky, and inside your 401K it's probably impossible.
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