You can't control tax laws or market returns, but you can control how you use accounts that offer tax advantages, and strategic decisions about their use can add significantly to your net returns. Where you put your investments, meaning the type of account you choose, will make a major difference in how much you can keep of what you earn over time. That's because different investments are subject to different tax rules, and different types of accounts have different tax treatment. Arranging your investments into different account registrations, is a strategy called asset location. Asset location has the potential to significantly lower your overall tax bill, as well as your beneficiary's tax bill.
Most investors are familiar with the importance of Asset Allocation--balancing risk and reward in your portfolio by diversifying investments through equities, fixed income, and cash, which is the cornerstone of portfolio design. However, focusing on allocation solely will mean missing out on the opportunity to maximize portfolio returns through increased tax efficiency. Implementing an optimal Asset Location strategy, along with having a appropriate allocation in place, can help you lower your tax bill. Asset Location is a tax-minimization strategy that leverages the fact that different types of account registrations have different tax treatments. An understanding of these differences will help in strategically allocating your investments between taxable, tax-deferred, and tax-free accounts. Most investors have several different types of accounts that should be aligned with specific investing goals. Some accounts are subject to taxes every year, while others have potential tax advantages. Here are the main investment account categories:
Taxable - Offers no tax deduction for contributions and requires 1) ordinary income taxes be paid yearly for ordinary dividends, interest, and short-term gains and 2) capital gains taxes be paid on qualified dividends and long-term capital gains when assets are sold. Examples would be individually or jointly owned taxable investment or brokerage account.
Tax-deferred - Allows you to potentially deduct your contribution now, and delay paying taxes until the funds are withdrawn. Any growth and income is tax deferred and withdrawals are taxed as ordinary income. Examples would include 401(k)s, 403(b)s, Annuities, and IRAs.
Tax-free - You save after-tax money and avoid any future taxation (as long as IRS rules are followed). All growth and income, as well as future withdrawals are tax free. Roth IRAs, Roth 401(k)s, and Roth 403(b)s are examples of tax-free accounts.
Just like most other aspects to wealth management, implementing the appropriate asset location strategy is not one-size-fits-all. The optimal location for your assets depends on many variables, including income, investment time horizon, goals (including legacy), tax status, and return characteristics of your portfolio’s securities. In addition, current and future tax law should be considered.
In my experience, after the introduction of this topic, clients often have the following questions:
Who Benefits from Asset Location Strategies?
You typically get the most benefit utilizing a combination of all of the above listed account types. When you have equity, fixed income, and cash in your portfolio, you typically have more flexibility to utilize asset location strategies. Even if your portfolio isn’t balanced with stocks and bonds, there are still benefits possible.
How Does Asset Location Minimize Taxes?
For Asset Location purposes, how a security is taxed will determine where it should be located. Long-term capital gains and qualified dividends (typically from equities) are given favorable tax treatment. Depending on taxable income, those rates could be 0%, 15%, or 20%. Taxable interest and ordinary dividends (typically from fixed income) are taxed at ordinary income tax rates (up to 37%). For some, allocating equity in a taxable account and fixed-income in a tax-deferred vehicle could improve portfolio tax efficiency. Although this may be favorable in many instances, it isn’t always the case as your current and future tax brackets, as well as other variables could impact what is optimal in your situation. The addition of tax-free accounts also can change strategies significantly, as you would want to have your maximum growth options in those account types. This is an area where an experienced wealth management professional can offer you significant benefits.
Tax-Advantaged Investments
The following assets are generally more tax advantaged, or tax efficient, if held for longer than 1 year.
Individual stocks
Equity index mutual funds and Exchange-Traded funds (ETFs)
Equity funds that name tax efficiency as a primary focus
The following are generally less tax advantaged
Bonds and bond funds (except tax-free municipal bonds)
Actively managed stock funds with high turnover rates
Real Estate Investment Trusts (REITS) Somewhat in the middle as generally 80% is taxed as ordinary income and 20% tax-exempt
Key Considerations?
As with most tax strategies, the higher the income tax bracket, the bigger the potential benefit of asset location.
Do you have large balances in tax-inefficient investments held in taxable accounts? The larger this position, the more advantageous asset location becomes.
The longer the time horizon, the more benefits you receive from strategic asset location.
Tax-efficient asset location could be helpful in reducing future IRS Required Minimum Distributions (RMDs).
What are you legacy goals? Asset Location strategies can have huge impacts for your beneficiaries. This could be the difference between your beneficiary pay close to 50% in tax in some situations, or 0%.
Final Thoughts
Application of optimal Asset Allocation and Asset Location strategies are key to a successful wealth management plan.
Asset Location can aid in maximizing your portfolio's net total return through tax minimization strategies
Selecting the best location for a particular investment can be quite complicated and you should consider working with an experienced Financial Professional to determine the best approach.
Whether it’s managing risk for our clients through strategic asset allocation or leveraging asset location strategies to create maximum tax efficiency. The process of developing an Asset Location strategy is complicated, and will need to be crafted for each investor differently. Our team at Legacy Wealth Planning Group works closely with our clients and customizes each portfolio to meet their specific financial needs. Schedule a free consultation to see how we can help.
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