Taxable Accounts vs Tax-Deferred Accounts

The new tax rates raise questions as to how your investments should be allocated between your taxable accounts and your tax-deferred retirement accounts (401(k), IRA). Under the new law, the highest marginal rate for qualifying dividends is 15% and also 15% for most long-term capital gains (owned for more than one year). The highest rate for ordinary income items (interest, short-term capital gains, wages) is 35%.

Previously, the conventional wisdom was to hold equities (stock) in taxable accounts and debt (bonds) in tax-deferred accounts. The new tax rates further strengthen this position for most investors. The reason for this is that qualifying dividends and most long-term capital gains will be taxed at a top rate of 15% and interest income from bonds will be taxed at a top rate 35%. As a result, you get the biggest savings by having your bonds in tax-deferred accounts.

With the new law in mind, you should decide on the allocation of stocks and bonds that are appropriate for your goals, time horizon, and risk tolerance. Then determine the allocation between taxable and tax-deferred accounts. Always keeping in mind that investment decisions should not be driven solely by tax considerations. Also, the lower rates on dividends and long-term gains are effective only through the end of 2008. What happens after that nobody knows at this time.

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