The beginning of the year is a good time to reflect on our investment goals and plan for how to allocate our investment dollars going forward. If you are fortunate to have more than enough investable income to max out your IRA contributions, you will be faced with the question of which stocks you should buy in your IRAs and which you should buy in your taxable accounts.
I have seen a number of commenters on Seeking Alpha articles stating that they prioritize dividend growth stocks over capital gains plays for their IRAs so as to tax-shelter the dividends. In this article I will explain why I take the exact opposite approach in my Roth IRA and explain my priority list for which kinds of stocks to place where.
The conclusions of this article will primarily be of interest for the following kind of investor.
- You are in the accumulation phase and you will be able to more than max out your IRA contributions for the year.
- You invest in a number of different kinds of things, possibly including REITs, MLPs, mutual funds, ETFs, traditional dividend growth stocks, and growth stocks.
- You only plan to take qualified distributions from your IRAs, and you won't need any of your investment income until then. For most Americans, this means you will not need your investment income until after reaching age 59.5.
- Your ending goal is a traditional dividend growth portfolio.
While this article is written from the perspective of using Roth IRAs (I do not have a traditional IRA), the results apply equally to traditional IRAs.
A little about me
As a younger dividend growth investor (with leanings toward value investing and growth-at-a-reasonable-price investing), my goal is to end up with a portfolio approximately 25 years from now that will throw off enough dividend income to meet my annual expenses and that will grow its dividend output at a rate exceeding inflation. I plan to get to the dollar amount I project will be required to own such a portfolio through a combination of investing in standard dividend growth companies like Coca Cola (KO), Chevron (CVX), and Johnson and Johnson (JNJ) right now, investing in low-yield/high-growth dividend growth companies like Ross Stores (ROST) and Visa (V), investing in straight-growth companies like Google (GOOG), and making capital gains plays with undervalued companies like Aflac (AFL), Deere (DE), and Teva (TEVA). Since I plan to have a 100% traditional dividend growth portfolio within 5 years of retirement, I will need to sell several of my positions along the way and use the proceeds from those sales to buy traditional dividend growth stocks later.
Before we begin I would like to state that I am neither an investment professional nor am I certified in any way as a tax advisor. I am simply going to lay out how I choose where I make my purchases and my rationale for these choices.
MLPs and REITs
While this article is primarily about the placement of dividend growth stocks, for the sake of completeness I feel I should say a little bit about Master Limited Partnerships and Real Estate Income Trusts.
Since distributions from MLPs such as Kinder Morgan Partners (KMP) are generally tax-advantaged already, I see little point in holding them in IRAs. In addition, if you hold an MLP in an IRA, it is possible for you to be subject to UBTI (unrelated business taxable income) tax. There have been many articles published on Seeking Alpha about the benefits and dangers of holding MLPs in IRAs, which I do not intend to rehash here.
On the other hand, since a large portion of the dividends from REITs usually consists of ordinary income, if held in a taxable account this income would normally be taxed at the investor's income marginal tax rate instead of at the usual (lower) qualified dividend rate. For this reason REITs are the number one priority for my IRA.
This brings us to the real meat of the article.
Why I hold stocks I intend to sell in my IRA and stocks I intend to hold forever in my taxable account
Mutual funds and ETFs are included under the "stocks" umbrella here. After REITs, my priority for placing investments into my IRA are the following.
- Highest priority: Stocks I know I am going to have to sell eventually, including mutual funds, ETFs, growth stocks, and most capital gains plays.
- Second priority: High-growth dividend growth stocks. Think stocks with 1% yield and 15% growth such as Ross Stores and Visa here. These are capable of building up very nice yields on cost over the course of several decades, but are more likely to be capital gains plays in the end.
- Third priority: Dividend growth stocks with strong current earnings but questionable futures. Think tobacco and technology stocks here.
- Fourth priority: Any other dividend growth stocks I think I might need to sell at some point in the future to meet my goals, in order by the probability that I think I will need to sell them.
- Fifth priority: Dividend growth stocks I plan to hold forever.
- Lowest priority: Any speculative investment. You cannot claim a capital loss for tax benefit in an IRA, so if you buy something while thinking that there's a decent chance that you may have to eat a capital loss on it, it's probably better to do so in a taxable account.
Based on these guidelines, I hold stocks such as my REITs, Google, Visa, and Ross in my IRA, while I hold stocks like Coca Cola, Chevron, and Johnson and Johnson in my taxable account.
Intuitively, the reason I do this is simple. When you hold a stock in the world's most dominant businesses for a long time you are going to build up large capital gains. Unrealized capital gains are not taxed. It's that simple! However, there is a bit of a sticking point: you will have to pay tax on the dividends along the way. To explain why that's better than sheltering the dividends along the way, assuming you have an equally-attractive stock that you don't intend to hold forever that you'd also like to buy right now, we need to look at some examples.
An example in detail
Let's say you have $11,000 to invest right now. The 2014 limit for Roth IRA contributions for those of us under age 50 is $5,500, so let's say you'll split up your investment dollars equally between your IRA and your taxable account. I am going to assume an immediate 15% tax on dividends and a 15% tax on realized capital gains, and I am also going to assume that you reinvest all dividends along the way.
Say you'd like to purchase a dividend growth stock (DG stock) that yields 3% and grows its dividends, earnings, and stock price by 7% annually that you intend to hold forever, and a growth stock that doesn't pay a dividend but grows in value by 11% annually, which you intend to sell for profit later.
Assuming that those numbers continue to hold, after 20 years in a taxable account and after having accounted for the taxes on the dividends along the way, the DG stock would grow to $35216.93 in value and be sitting on $21382.39 of unrealized capital gains, while the growth stock would grow to $44342.71 in value, but when sold has to pay taxes on $38842.71 of capital gains, for an ending value of $38516.30 after taxes.
On the other hand, after 20 years in a tax-sheltered account, the DG stock grows to $38439.94 in value, while the growth stock grows to $44342.71 in value.
Here's where things get fun. If you put the growth stock in your taxable account and the DG stock in your IRA, after 20 years and accounting for the tax on the sale of the growth stock, your total asset value is $76956.24. On the other hand, if you buy the same stocks but in the opposite accounts, in 20 years and after the sale of the growth stock, your total asset value is $79559.64 (including the $21382.39 of unrealized capital gains, which you never intend to realize anyway), which is about 3.38% higher. Congratulations! You just earned yourself the ability to lay claim to 3.38% more dividends based on nothing more than where you chose to place your assets 20 years ago.
This example is not a fluke. The average case is actually even better.
Let's see what happens when the numbers change in the above example. Say you have equal dollar amounts to allocate to two stocks, a DG stock that you never intend to sell and a growth stock that you intend to sell in 20 years. One stock will be held in a taxable account, and one will be held in a tax-sheltered account.
The following table shows the percentage-advantage in total asset value 20 years from now that comes from the choice today of purchasing the DG stock in the taxable account and the stock you sell after 20 years in the tax-sheltered account rather than the other way around. I chose what I believe to be reasonable long-term yields and growth rates for dividend growth stocks and growth stocks in constructing the table. The 5%-yield 3%-growth DG stock is meant to represent the average utility. If you would like to see the result for another combination of stock qualities, please leave a comment!
|DG stock yield, growth rate (held at 20 years)|
|2.0%, 7.0%||2.0%, 8.0%||2.0%, 9.0%||2.0%, 10.0%||2.5%, 6.0%||2.5%, 7.0%||2.5%, 8.0%||2.5%, 9.0%||3.0%, 6.0%||3.0%, 7.0%||3.0%, 8.0%||3.0%, 9.0%||5.0%, 3.0%|
|Growth stock yield, growth rate (sold at 20 years)||0.0%, 10.0%||4.56%||3.62%||2.7%||1.81%||4.38%||3.37%||2.36%||1.4%||3.2%||2.12%||1.07%||0.07%||2.05%|
In only one of the 247 scenarios above is the total payoff higher when you purchase the DG stock in the tax-sheltered account.
Here are the statistics of the 247 cells in the table.
- median: 4.64%
- mean: 4.65%
- standard deviation: 1.99%
Here is the histogram of values in the above table.
So there you have it! By eschewing the conventional wisdom of prioritizing dividend growth stocks for my IRA and instead prioritizing for my IRA the stocks I expect I may have to sell later to complete my dividend growth portfolio, 20 years from now I expect to end up with about 4.5% more in total account value, after all applicable taxes are paid.
Some additional comparisons
While the table above is not a complete analysis of all possible combinations of factors, the conclusion that one is generally better by having the lowest priority for buy-and-hold-forever dividend stocks for their tax-sheltered accounts is generally true.
Let's look at tobacco, for instance. Although you may disagree, I'm not sure big tobacco is still going to be around and profitable 20 years from now, so while I hold some now, I am planning for the fact that I might have to sell it at some point. Let's compare a tobacco stock that yields 4% and that grows earnings and distributions at 7.5% annually, versus a DG stock that I never sell, which yields 3% and grows at 7% annually. Here are the percentage gains in total asset value from choosing to hold the tobacco stock in the tax-sheltered account and the DG stock in the taxable account rather than vice-versa.
- 2.61% if the tobacco stock is sold after 5 years.
- 4.64% if the tobacco stock is sold after 10 years.
- 6.39% if the tobacco stock is sold after 15 years.
- 8.01% if the tobacco stock is sold after 20 years.
Let's also go back and look at the 3%-yield, 7%-growth DG stock that I never sell versus the no-yield, 11% growth stock that I eventually sell over different time periods. Here are the percentage gains in total asset value from choosing to hold the growth stock in the tax-sheltered account and the DG stock in the taxable account rather than vice-versa.
- 2.10% if the growth stock is sold after 5 years.
- 3.12% if the growth stock is sold after 10 years.
- 3.45% if the growth stock is sold after 15 years.
- 3.38% if the growth stock is sold after 20 years.
- 3.07% if the growth stock is sold after 25 years.
- 2.65% if the growth stock is sold after 30 years.
The difference remains positive all the way out until 60 years, at which point the sheer growth of the growth stock outpaces the tax advantage gained by sitting on unrealized capital gains on the DG stock. However, very few growth stocks manage to remain growth stocks for over 60 years, and furthermore very few investors have 60 year time horizons before they need to begin drawing income from their accounts.
Additional benefits of this asset placement choice
By holding my growth stocks and capital gains plays in my IRA, I am also able to buy and sell positions without incurring capital gains taxes. In effect, if I find one high-growth stock now whose growth slows in 10 years, I can sell it and buy another high-growth stock and hold onto that for another 10 years in my IRA with virtually no penalty. While I do this the unrealized capital gains of my DG stocks in my taxable account just continue to grow. On the other hand, the penalty for selling one growth stock and moving onto another in a taxable account is significant.
In addition, if you are able to find a nice growth stock and hold onto it for many years in a taxable account, when it is time to sell it you might be forced to pay a higher capital gains tax, depending on the size of the gain. This further cements in my mind my choice to hold stocks I intend to sell or stocks I think I might need to sell in my IRA.
A third benefit to this approach is that your growth stock investments are likely to outpace your dividend growth investments in total return over longer periods of time. While this point might be somewhat controversial in the DGI community, I think about it in this way. Do I think an investment in Google and Visa today is going to be worth more than an investment in Coca Cola and Chevron in 20 years? Yes I do, but I'm not going to bank on it so I choose to own all four. By placing my growth stocks in my IRA I give myself a good chance of having a larger percentage of my total assets in my Roth IRA when I retire, thereby sheltering a larger percentage of my eventual dividend income.
Summary and conclusions
My first priority for holdings in my Roth IRA are REITs. After that, with the exception of speculative plays (which I hold in my taxable account for possible tax loss harvesting), I prioritize stocks for my IRA based on the probability that I think I might need to sell them at some point to realize my goals. The stocks with the highest probability of needing to be sold receive the highest priority for my IRA. Based on this approach to asset placement I expect that I will end up with approximately 4.5% more in total assets, after all taxes are paid on all dividends and all capital gains that I intend to realize, than I would have if I had prioritized dividend growth stocks for my IRA instead.
All computations were performed and all tables and graphics were produced with the mathematics software package Sage.