Help Reduce your Investment Related Taxes through Asset Location
Most people are familiar with the term Asset Allocation, meaning the mix of various asset classes you’re invested in and the weighting they represent of your portfolio (i.e., 60% Stocks to 40% Bonds). What I’ve found over the years of being a financial planner is that not as many people are familiar with the term Asset Location. This blog will dive into the concept of Asset Location and how implementing it can help reduce your taxes on an ongoing basis, allowing you to keep more of your investment returns.
Asset Location is the strategy of holding your tax-efficient investments in your taxable accounts, and your tax-inefficient investments in your tax-advantaged accounts, without sacrificing your Asset Allocation.
What do I mean by this? When reviewing portfolios, I will commonly see people invest each account of theirs in the exact same manner. If they have a Taxable Account, a Traditional IRA, and a Roth IRA, and they have a Target Asset Allocation of 75% Stocks to 25% Bonds, they will be 75 / 25 in each of their three accounts. While this makes the management of the portfolio easy and convenient, it’s not the most efficient way to manage your portfolio and could lead to increased taxes, in turn, lowering your net return on investment.
Asset Location uses the advantages (and disadvantages) of each account type to your favor by placing specific asset classes in specific account types. It’s important to have an understanding of how certain account types are taxed, as well as have an understanding of the tendencies of each type of investment you invest in.
From the account perspective, Taxable Accounts, like Individual and Joint Brokerage Accounts, and Revocable Trust Accounts, receive different tax treatment than Tax-Deferred Accounts such as Traditional IRAs, 401(k)’s, and 403(b)’s. Similarly, both Taxable Accounts and Tax-Deferred Accounts receive different tax treatment than tax-free accounts such as Roth IRAs, Roth 401(k)’s, and Roth 403(b)’s.
From an investment perspective, different investment types have different tendencies in how they generate their total returns. Stocks, compared to Bonds and Cash, tend to realize a lot more of their return from Capital Appreciation. Meanwhile, Bonds (mostly) aren’t earmarked for Capital Appreciation, but rather steady income.
When it comes to stock mutual funds, you have active and passive. That describes their management style. Passive stock mutual funds tend to be more tax-efficient than active mutual funds. That is because there tends to be more trading going on within an active fund than a passive fund. With increased trading may come increased capital gains being realized, which get passed onto you as the investor. If you’re investing within a taxable account, those capital gain distributions that get passed onto you get added onto your income for that year. So, it’s generally more tax-efficient to invest in passive stock mutual funds in a taxable account compared to an active mutual fund.
A great place to hold your actively managed stock mutual funds would be your Roth IRA. Not only are the capital gains distributions not taxable to you, but the growth you achieve within the investment is tax-free too. This is why I like to avoid bonds in a Roth IRA if I have the shelf space in a tax-deferred IRA instead. You want to take advantage of that tax-free growth the Roth IRA has to offer by putting your highest anticipated growth assets in that account. Of course, any given year, a bond fund can outperform a stock fund. But, historically speaking, stocks have outperformed bonds over the long run. Would you rather that growth be taxed at your ordinary income rates when you distribute (tax-deferred), or would you rather that growth be completely tax-free (Roth)?
Again, all this is done while keeping your asset allocation intact. Because that is the most important part of your investment portfolio. You don’t want to abandon your asset allocation just to save on taxes. So, some portfolios may have bonds in a Roth IRA or Taxable account. That’s okay. The goal is maximizing your shelf space with each account type while maintaining an appropriate asset mix.
Some of the major benefits to utilizing an Asset Location investment strategy:
Potential Reduction in Current Year Taxable Income
As mentioned, bonds are income producing investments. They provide some capital appreciation, but they are more earmarked for steady income. Bond mutual funds distribute monthly interest to you, which is a great thing. However, that monthly interest is taxable to you during that given year.
If I had a $250,000 bond mutual fund in my taxable account and it yielded 5% for this year, that bond mutual fund would’ve distributed me with $12,500 of interest. Again, a good thing. But that $12,500 would be added to my gross income for the year. Say I’m in the 24% Federal Bracket, I would owe $3,000 in taxes for that interest. That makes my net return on that interest $9,500, not $12,500.
(Disclosure: Please note, the examples being shown throughout this blog are hypothetical and for illustrative purposes only. Actual results may vary substantially.)
But if I had instead invested that $250,000 bond fund in my 401(k), that $12,500 in interest payments does not get added to my gross income for the year. Saving me $3,000 in taxes for that year.
Potential Reduction in Future Taxable Income (Long-Term Capital Gains versus Ordinary Income)
Continuing with the example above, let’s also say this investor has a $250,000 stock mutual fund. Stocks being a growth asset instead of an income asset, we anticipate this fund to provide us with more capital gains than income over the years. We prefer capital gains to be in our Taxable Accounts over our Tax-Deferred Accounts.
Say this stock mutual fund is held within this investor’s 401(k). The stock fund appreciates 8% and receives a 2% dividend. In total, returning 10% for the year, or $25,000. That’d be $20,000 in capital appreciation and $5,000 in income.
By holding this investment in his 401(k), he does save himself from having to add that $5,000 to his current year gross income. However, when this investor retires and begins to take distributions from his portfolio, that entire $25,000 in returns will be fully taxable. Every dollar that comes out of a tax-deferred account is taxed as ordinary income.
If this investor had instead invested in this $250,000 stock mutual fund within his Taxable Account, he would have to add that $5,000 of income to his gross income (much less than the $12,500 the bond fund produced). But the $20,000 in capital gains would be taxed at lower rates than his ordinary income when he would sell the fund (assuming he held the fund for at least 1 year).
Long-Term Capital Gains Rates in 2024 are:
Source: College For Financial Planning (as of 08.29.2024)
Assume this investor is a Single Filer. If his taxable income is between $47,026 and $518,900, he would pay 15% taxes on any capital gains. If your taxable income is between $47,026 and $518,900, you are paying a tax rate of anywhere between 22% - 35% on a 401(k) distribution.
This illustrates how realizing capital appreciation in Taxable Accounts compared to Tax-Deferred Accounts can save you taxes in the future as well.
Potentially Lowering Your Required Minimum Distributions (RMDs)
Pretty similar to the first two points but holding your bonds in your tax-deferred accounts is likely to lead to a lower overall return in your tax-deferred accounts in the long run. This is because, historically, stocks have outperformed bonds over long periods of time.
Tax-Deferred Accounts, like Traditional 401(k)’s and Traditional IRAs, have RMDs. Meaning, depending on your date of birth, sometime between age 73-75 you will be required to start taking distributions out of these accounts. Whether you need the money or not. Depending on the size of your account, these distributions can become quite large, especially later in life as the required % increases. For some people, these distributions are much more than they need, and the distributions end up pushing them into higher tax-brackets. So now, not only are they paying ordinary income taxes on all of their capital appreciation instead of Long-Term Capital Gains rates, but they may also be paying a higher ordinary income rate on some of that money, because the required distribution was so much that it pushed them into a higher marginal bracket (i.e., your RMD pushes you out of the 24% bracket and into the 32% bracket).
By having your more conservative investments in your tax-deferred accounts, and your riskier investments in your taxable and tax-free accounts, you position your future self to potentially have lower RMDs and better tax treatment of your capital gains.
Maintaining your Asset Allocation
This was touched on in the very beginning, but it’s very important. An asset location strategy should not impact your asset allocation. If you have a $1,000,000 portfolio and a target asset mix of 60% stocks to 40% bonds, you should still have a 60% stock to 40% bond asset mix using asset location. If you run out of shelf space in your Traditional IRA to house your $400,000 in bonds, then you start investing in bonds in your taxable account. This way your risk tolerance is not violated. And your gross returns won’t be impacted either. If you invest that $1,000,000 in the exact same funds, it’s going to produce the exact same returns, regardless of the account type. The difference in utilizing asset location is the amount of taxes you owe on those returns, hopefully reducing your taxes and improving your overall net returns.
Things to watch out for when implementing an Asset Location Strategy
While implementing an Asset Location Strategy comes with a lot of benefits as we just discussed, there are some things to keep in mind before implementing it.
1.) Capital Gains
If you are going to be rearranging your portfolio, it’s important to remember that selling in a taxable account may realize capital gains. Capital gains are taxable to you during the year that you sell. Realizing an insignificant amount in capital gains may be fine, but implementing an asset location strategy may not be best for you if it means realizing significant capital gains up front to implement the strategy.
2.) Accounts will react differently to investment returns / losses
If you shift most of your stocks funds to be held within your taxable accounts and Roth IRAs, and most of your bond funds to be held within your Traditional IRA, it’s important to recognize that these accounts will likely respond very differently to market movements moving forward. Stocks tend to be much more volatile, so in turn, your taxable account and Roth IRA may be much more volatile. If you are in the distribution phase of retirement and you are taking distributions from your taxable account, there may be periods that your account is down significantly due to the markets. Usually, you don’t want to sell your stock funds after a significant loss. This doesn’t mean you would avoid withdrawing from your taxable account at that time. How you get around that would be selling your stock funds in your taxable account to fund your withdrawal, then rebalance within your Traditional IRA. You’d sell your bond funds in your IRA and buy them back into the stock funds that you just sold in your taxable account. This way your stock allocation remains the same.
I’ll finish off here with what this would look like in theory. We’ll take two portfolios. Both are the exact same as far as account types and balances. The first portfolio will invest in an equally weighted manner. Each account will be 60% Stocks / 40% Bonds across the board. The second portfolio will utilize the asset location strategy we just discussed, which will allow you to see the difference.
Again, please review with a financial planner or accountant before moving around your investments. Especially within your taxable account. Selling or exchanging positions within your taxable account is a taxable event and could potentially cause you an unexpected tax bill at the end of the year if you’re not cautious.
As always, I appreciate you taking the time to read. Please feel free to reach out if you have any questions. We utilize asset location strategies within our clients’ retirement portfolios to help them minimize their overall taxes throughout retirement. If you feel you’d benefit from utilizing this as well, we are happy to touch base and see if we can help.
Thanks again and have a great day.
Drew Schaffer, CFP®
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