Proper Asset Location to Increase After-Tax Wealth
Most investors are familiar with the concept of asset allocation, which refers to the composition of asset classes within a portfolio. However, many are likely not as familiar with the concept of asset location.
Asset location refers to the type of investment account that is being used to hold specific investments. A thoughtful asset location strategy can provide results that are well worth the effort.
First, a refresher on the most common account types:
1. Taxable accounts (taxable brokerage accounts)
• Contributions: No upfront tax deduction.
• Income and growth: Interest, non-qualified dividends, and investments held for one year or less are taxed at ordinary income tax rates. Investments held for over one year and qualified dividends are taxed at lower long-term capital gains (LTCG) rates.
• Withdrawals: Any realized gains from sales are subject to capital gains taxes.
2. Tax-deferred accounts (traditional IRAs, traditional 401(k)s)
• Contributions: Qualified contributions are generally made on a pre-tax basis.
• Income and growth: Income and capital gains are not taxed until withdrawn.
• Withdrawals: Qualified withdrawals are taxed at ordinary income tax rates.
3. Tax-exempt accounts (Roth IRAs and Roth 401(k)s)
• Contributions: No upfront tax deduction.
• Income and growth: Not subject to additional taxes if withdrawals are qualified.
• Withdrawals: No taxes on qualified withdrawals.
Choosing the Correct Asset Location
The correct account type is not a one-size-fits-all solution and varies depending on tax situation, asset allocation, goals, and other factors. Generally, it is ideal to have a mix of account types to provide flexibility with tax and distribution planning in retirement.
Now, for some specifics:
Income-producing assets, or other tax-inefficient investments, such as taxable bond funds, actively managed mutual funds, and precious metals funds, are generally better held inside tax-deferred accounts to avoid current-year income tax consequences. Remember, in tax-deferred accounts, taxes are paid only upon withdrawal.
These types of assets are also strong candidates for tax-exempt (Roth) accounts. An additional consideration is that it can often make sense to allocate more aggressive investments to Roth accounts due to the benefit of eventual tax-free distributions and the absence of required minimum distributions in retirement.
Meanwhile, tax-efficient assets such as long-term stocks, passive ETFs, and municipal bonds may be better suited for taxable accounts. These assets typically have limited tax implications (outside of dividends or interest) until sold. Furthermore, if held for longer than 12 months, gains are taxed at preferential long-term capital gains rates. Taxable accounts can provide much-needed flexibility, and when paired with tax-efficient investments, the overall tax burden can be minimized.
Final Thoughts
According to research from Charles Schwab, an effective asset location strategy can increase annual returns by up to 40 basis points. While this may not sound significant, over a 30-year period it can translate into roughly a 10% increase in real wealth, potentially equating to hundreds of thousands of dollars.
While asset location is just a small piece of the overall pie, it is an important detail that should be planned and is a small component of the value we strive to provide our clients with.
As always, please consult with a financial and tax advisor before making account-related decisions.
-Bill Rautiola, RICP ®, AIF ®, PPC ®
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Asset allocation does not ensure a profit or protect against a loss.
Stock investing includes risks, including fluctuating prices and loss of principal.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Wealth Strategy Group, LLC and LPL Financial do not provide legal advice or tax services. Please consult your legal advisor or tax advisor regarding your specific situation.
