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Jim,
I think you are saying you want funds in your 401 or IRA that generate capital gains, since the tax on those gains is deferred until you are in a lower tax bracket.
Am I understanding you correctly?


Centex,
Not exactly. My argument doesn't really turn too much on your tax bracket today vs. tomorrow (though it is a function of your age -- my argument applies most clearly to younger workers in the 20-40 range).

In general, it's always better to defer taxes until tomorrow rather than pay them today (assuming real interest rates are not negative), which is a basic "time value of money" concept that I'm sure must be explained elsewhere on the Motley Fool. More or less, it's that if you save that $100 this year (that you'd otherwise pay the government), you'll have $(100+r) next year, where r is your rate of return. So even if you have to pay the government the $100 next year, as well as pay the government tax on the return, you wind up with $(r - tr) extra dollars, where t is your tax rate.

The big advantage of tax deferred accounts like IRAs and 401(k)s is that you pay no current tax on either capital gains or current income (dividends or interest). (Lower income taxpayers can also take advantage of Roth IRAs, which let you avoid tax altogether rather than merely defer it; and taxpayers without 401(k)s can deduct current contributions to their traditional IRA.) Thus, if you're 30 today, you can hold an investment for the next 35 years paying no tax on either dividends paid or capital gains realized in the tax deferred accounts. (If you're near retirement age, the tax situation is more complicated, since you can be paying ordinary income tax rates tomorrow vs. capital gains, so be careful.)

This is a HUGE advantage, more the higher your tax bracket is. Consider: if you pay 50% of your income in taxes but get a 10% return, you only get 5% after tax; but if you don't pay that tax, you still get 10%. Over time, this advantage compounds and compounds: $100 today becomes $1,745 in 30 years with a 10% return, but only $432 with a 5% return. That's why tax deferred accounts are so powerful. But broad market index funds lose a good bit of this tax value, since the market's dividend payout ratio is low, and these funds have low turnover since they merely track an index.

Thus, assuming you hold some sizable investments outside your 401(k) and IRA, it's advantageous to focus tax deferred accounts on high tax holdings (i.e., those that realize high current income through high dividend/interest payouts and/or turnover-related capital gains), while focusing taxable accounts on low tax holdings (i.e., those that realize low current income by paying little or no dividends/interest and having lower turnover). Of course, because capital gains are tax deferred already (only paid when realized), and taxed at lower rates, the tax advantage is most significant for funds that pay out high current earnings in dividends or interest.

Also, note that one advantage to investing your IRA (and 401(k)) in multiple, diversified funds over time is that you get to rebalance your portfolio tax-free whenever you want -- something you can't do in taxable accounts. Theory and empirical evidence suggest that some diversification with regular, transaction-cost-free rebalancing can beat an all-U.S.-equities portfolio return. The theory and empirics are too complicated to go into here, but I don't think most investors will hurt themselves by keeping a limited portion of their portfolios in commodities, bonds, and real estate and regularly rebalancing -- and because 401(k)s/IRAs let you do that for free, they're the perfect vehicle for it.

Now, this argument isn't in any way meant to slam index funds. I think that most investors are best served primarily by investing in the market index. If all you're saving is your retirement account, invest that primarily in an index fund. And a lot of investors may prefer to put all their savings in index funds, due to a lack of sophistication; this strategy can work fine -- they'll make out well in the long run. But a lot of actively managed funds do in fact beat index funds on a pre-tax basis, and have relatively low management fees,* so you may well wish to consider active funds for the tax deferred portions of your portfolio. The broader point is that if you hold a mix of actively managed and index funds, you should (generally) concentrate the actively managed funds in the tax-free account, the index funds in the taxable account.

*A couple of examples from Vanguard, with 10-year track records: Windsor (0.36% management expense, 14.4% pre-tax return vs. 12.94% S&P 500 & 14.16% Russell 1000 Value Index), Explorer (0.64% management expense, 12.97% pre-tax return vs. 7.19% Russell 2000 Growth Index).

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