High Tax Efficiency Can Be Better than Tax Deferral
April 06, 2000

High Tax Efficiency Can Be Better than Tax Deferral

Q. What is the rule of thumb about whether it makes sense to put after-tax dollars in a 401k? My husband (50) and I (40) contribute 20 percent of our salaries to our 401k plans. My husband does not hit the max pre-tax contribution but I do and then I must convert to post-tax contributions. We fully fund Roth IRA's and have $70,000 in equities outside retirement accounts.

Would it make more sense to buy and hold individual equities with what would have been my after-tax 401(k) contribution? Stock appreciation won't be taxed until I sell so the tax deferral of the 401k is irrelevant. When we retire (10-15 years) and begin to sell stocks, the taxes on the capital gains will be 20 percent versus a marginal tax rate of at least 28 percent for 401k withdrawals.

Our 401k funds have been doing extremely well and I don't think I could have beaten their return over the last two years. Maybe it's worth the tax penalty to have the money professionally managed. Any thoughts?

---L.E., Cincinnati


A. Qualified plans are an area of tax law and accounting that is extremely complicated and where small errors can be very expensive. For that reason, I suggest that you keep your tax-deferred money in one place and your taxable money in another. When you hit the max on your 401k, put your additional funds in another investment.

This could be a portfolio of individual stocks--- with all the advantages you suggest--- or it could be in a mutual fund that is managed for tax efficiency. While index funds are the first thing that comes to mind in this area, it is possible to be managed and tax efficient. The end result is that tax efficiency can be a good alternative to tax deferral.

Let me give you an example. Thornburg Value Fund A shares have a 94.75 percent tax efficiency figure (over the last three years) from Morningstar. That's not so far from Titans of Tax Efficiency such as Vanguard Index 500 (96.19 percent) or the tax managed Schwab 1000 (98.21). The subject of a column September 15, 1998, Thornburg Value provided a return of 36.99 percent in 1999, putting it in the top 19 percent of its category. (You can find the column on my website)

While it is possible to buy individual stocks and hold them, tax avoidance really shouldn't influence what stocks you hold and what stocks you sell. (For a lovely example of how it can become difficult, read the next question.)

Unless you are a relatively sophisticated investor, ready to make buy and sell decisions, investing a good, tax efficient mutual fund is likely to have the best pay-off.


Q. I invested $14,000 in Qualcomm over a year ago and now own nearly $500,000 worth in my pension plan. This now makes up nearly one third of my retirement plan, which is composed of about 15 stocks (mostly technology) and six funds (technology, global, and Vanguard Index 500.

Should I sell some? Also, what is your opinion on investment advisors for those of us with assets in the $1 million to $3 million range? Fee-only vs. commission, and not just for investment advice, but for estate planning as well?

---E.C., Dallas


A. First, don't ever forget that this is a great problem to have. From a portfolio point of view the answer is easy: sell up to half of the Qualcomm, taking it down to about 15 percent of your total portfolio. This will reduce your volatility   risk. But it will also reduce your exposure to a terrific company that has a lock on the next generation of wireless phone technology. Even with no tax consequences, this will be a lot harder to do than to say. I suggest you do it in a new framework: decide that you will put more structure in your portfolio and then use that structure as a guide to sales. Almost any structure would tell you to start taking some profits. The issue is how much--- you don't want a strict policy that forces you to sell your winners prematurely.

I'd keep the estate planning separate from the investment advice. You can go a long time between estate plans but investment management is a 24/7 kind of thing. My suggestion: interview investment advisors and find one you feel comfortable with. Then ask for an estate planner recommendation.

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