Juggle Your Taxed and Tax-free Accounts

Physician's Money Digest, July15 2003, Volume 10, Issue 13

Many physician-investors in high taxbrackets are concerned that when theyretire, they won't see an immediate,significant drop in their marginal tax rate.Physicians should consider taking a differentapproach to retirement planning than investorswhose tax burdens fall substantiallyupon retirement. They may want toconsider rebalancing their overallinvestment assets between taxable andtax-deferred accounts. Instead of treatingtheir assets as entirely separateportfolios, they should think of themas closely related portfolios that arepart of a long-term plan.


Of course, retirement assets aren'tmanaged solely for tax efficiency. Thefirst goal of retirement planningshould be to determine how thoseassets fit into an overall financial plan.Is the money being set aside to provideretirement income, or is it earmarkedfor heirs or charity? How much income will yourretirement portfolio need to generate, and howmuch risk should you take to reach that incomelevel? Do you have near-term funding needs (eg,college tuition)? These kinds of questions shouldbe answered before any decisions are madeabout investment strategies for a portfolio thatincludes retirement and nonretirement assets.

While many investors have been rebalancingtheir portfolios following a 3-year bear market inequities, they should not lose sight of long-termobjectives. Boosting fixed-income holdings at atime when interest rates may rise could turn outto be precisely the wrong strategy. At the sametime, cutting long-term equity holdings just asequity prices reach new lows may also be thewrong approach.

For physicians with substantialretirement and nonretirementportfolios, strategic assetallocation decisions may be helpfulin avoiding these pitfalls andimproving assets' taxefficiency. When selectinginvestments fortaxable and nontaxableportfolios, some assetclasses are more effectivethan others. Traditionally,investors havebeen advised to consideroverweighting tax-favored investmentslike municipal bonds in taxableportfolios. At the same time,equities intended to be long-termholdings are better off in a tax deferredretirement fund. However,with the introduction of new assetclasses like alternative investments,the asset allocation process has managedto become more complex.


One approach to asset allocation between taxableand tax-deferred portfolios can be illustratedwith a $2-million portfolio belonging to ahypothetical 40-year-old physician, who is also afather of 2. This doctor has both short-termneeds, including college tuition and a down paymentfor a new home, and long-term needs forhis retirement income. The doctor's investmentobjective is balanced growth, with 60% in equitiesand 40% in fixed income.

Let's assume in this example that the assetsare split in half—$1 million in a taxable accountand $1 million in a tax-deferred account. Theasset allocation could go as follows:

• Tax-deferred account. Hecould place 20% into corporatebonds or bond mutual funds,including both investment-gradeand high-yield issues. The relativelyhigh current income from theseinvestments would be tax-deferred.Another 20% could go into hedgefunds or another alternative, especiallythose with higher turnover.Again, the benefit of this asset allocationis to defer taxes on short-termrealized capital gains.

• Taxable account. He couldchoose to place 60% of this portfolio into tax-freemunicipal bonds. The other 40% might gointo a broadly diversified equity portfolio. Thisportfolio would consist of carefully selected largecap, mid cap, and small cap stocks.

Whatever investments you select, monitoringthe performance of your portfolio is essential,especially during periods of higher volatility. Andin most cases, especially for more complex orsophisticated needs, investors should also seek thehelp of an investment professional. The hypotheticalasset allocation outlined above won't work forevery investor. Older physicians may want toincrease the bond allocation in both their taxableand tax-deferred portfolios, and use a ladderedapproach with bonds of varying maturities thatwould allow them to take advantage of rising interestrates. Younger investors may want to increasetheir equity allocation, particularly if they won'tneed the money for several years.

In either case, rebalancing taxable portfoliosand retirement portfolios requires a strategic long-termapproach. Each physician-investor needs toevaluate their own goals and personal circumstances,and design a plan that works for them.

Robert S. Bridges, Jr,

senior VP of Fiduciary

Trust Co International

in New York, manages

portfolios of high-net-worth

individuals and

trusts. He welcomes

questions or comments

at 212-632-3327 or

rbridges@ftci.com, or

for more information

visit www.ftci.com.