A properly structured investment plan offers consideration to the ongoing taxation of wealth during the accumulation phase.
As the saying goes, “It’s not what you earn that matters, but rather what you keep.” Bearing this in mind, it’s important to recognize that investment returns and success should be measured on an after-tax basis. Taxes can exact a steep toll, so it’s worth knowing more about how to benefit from tax-efficient asset location practices.
What is Asset Location?
Asset location should not be confused with asset allocation.
Asset allocation is a process whereby portfolio assets are divided among different investment types to achieve a desired level of expected risk and return. It is commonly expressed as the percentage holdings between equities and fixed income. A “60/40” portfolio references 60 percent ownership of equities and 40 percent ownership of fixed income across the portfolio. Asset allocation is usually an early and important step in constructing an investment plan.
When possible, investments with highly effective tax rates should be sheltered in accounts that receive tax-deferred treatment. Following this process may improve your after-tax returns on the entire portfolio and maximize your wealth.
The Process of Asset Location Management
As an investor, you know that many investors and their advisors manage portfolios at the account level—meaning accounts are managed separately without considering other account types. For example, if an investor’s asset allocation calls for 60/40, it is common to see each account follow this same allocation, holding the full “pie” in each account. This process isn’t necessary, and in the following discussion, you can see why a different approach creates more wealth.
As previously noted, the basic idea of asset location management is to place investments with tax-inefficient characteristics into tax-deferred accounts, tax-efficient investments in taxable accounts, and high expected return investments in Roth IRA accounts. For example, fixed income and alternative investments are notoriously tax-inefficient due to the nature of their returns (which are taxed at higher ordinary rates and experience high turnover). These assets are prime candidates to hold in tax-deferred accounts.
Equities, to provide another example, are known to be tax-efficient, as they receive preferential capital gain and qualified dividend tax treatment and are taxed at a lower effective rate. Since equities have a significant capital appreciation component to the total return, you can delay taxes for long periods of time and control, to a degree, the timing of gains. As a result, it is preferred to hold equities in taxable brokerage accounts.
A good investment plan considers the proper ordering for the placement of different types of investment assets into different account types. This is a process that you can follow according to a documented hierarchy from least tax-efficient to most tax-efficient.
Implementing Asset Location Practices
While this concept is somewhat simple, implementation is another matter that should take into account certain trade-offs.
First, investors are often limited by capacity within their tax-sheltered or brokerage accounts. An investor who sells a business is more likely to have considerable wealth in their taxable brokerage accounts compared to tax-sheltered accounts. The opposite might be true for a professional that has saved rigorously through his or her workplace retirement account.
Eventually, you either spend or give away your wealth. A few ideas to consider in this regard:
- Considering Your Goals – An early step in the process should involve developing an investment plan that aligns with your objectives
- Planning the Timeframe – The timing of access to liquidity is important, as it may influence other objectives
- Diversifying Investments Across Account Types – Having assets in different account types gives you options when it comes to planning and uncertainties
Other Tax Planning Considerations
Holding equities in taxable brokerage accounts offers additional benefits beyond preferential tax rates:
- Foreign tax credits – The ability to use foreign tax credits that may accrue on international investments, which go unused in tax-deferred accounts
- Tax loss harvesting – Realizing the economic value of capital losses and doing so as early as possible without waiting until year-end
- Donating Appreciated Assets to Charity – By donating appreciated shares, capital gains can be avoided. This planning is most attractive with equities due to their high expected return
- Basis Step-up Upon Death – Securities in taxable accounts receive a step-up in basis upon the owner’s death, thereby eliminating capital gains. Equities have a higher expected return, and therefore, appreciation is likely to be much higher when compared with other types of investments
Finally, owning lower expected return assets, such as fixed income, inside tax-deferred accounts reduces future required minimum distributions from retirement accounts. Lower required distributions are often helpful when planning for future withdrawals and considering the impact of tax brackets, Medicare premiums, and the taxation of social security.
Improving Your Odds of Success
Holding stocks in taxable accounts and bonds in retirement accounts is contrary to the commonly held belief that growth assets should be kept in retirement accounts to maximize growth “for retirement.”
The benefits of maximizing asset location tend to be subtle, but the benefits accrue over time and the cumulative effect of tax savings profit from compounding just like any other return. Consider effective asset location within the context of holistic wealth management. It often calls for multi-disciplinary oversight across investment management, retirement planning, tax planning, and estate planning. Proper asset location can have a significant impact on the odds of achieving your financial goals.
Please contact us to discuss your situation with a wealth management professional.