Investments are important tools to help you reach your financial goals. There are many pieces that comprise your investment strategy and today we are going to talk about one that doesn’t receive a ton of attention but can have a big impact on your net gain: asset location.
I like to think of asset location like a house. Your house provides shelter and keeps you safe and warm. It is a place to rest your head and find comfort and security. Asset location seeks to provide that same idea of security for your investments.
Asset location is a strategy to help maximize your return by housing your investments in accounts that will receive more favorable tax treatment. It is a way to maximize your return by coupling the right securities with their corresponding accounts. Today, we are going to take a closer look at this investment strategy and demonstrate how it could change your approach to investing.
Breaking down asset location
Asset location aims to include tax-efficiency into your investment strategy by housing different securities (stocks, bonds, mutual funds, etc.) in accounts that will provide the most favorable tax treatment (tax-deferred, tax-exempt, or taxable).
This tactic differs from its neighbor, asset allocation in key ways. Asset allocation is concerned with the type of securities that make up your portfolio and how they align with your goals, priorities, and risk tolerance.
Once you have a portfolio that best reflects your goals as an investor, you can then start to think about putting those securities in a place to give them the best chance for success. Think about it this way, you probably don’t want to order a burger at a sushi restaurant. Not because the food would be terrible, but it isn’t what they are known for so it wouldn’t be nearly as good as the one at the steak house. This example illustrates that the same item (in this case the burger) can be housed in different places, but one place will ultimately be better and more profitable for you, the customer.
Now, let’s take a look at how this idea translates to your investments.
Housing your securities
Just like you have many different choices for housing (apartment, condo, townhouse, single-family, etc.) you also have choices for where to house your investments namely in either a tax-deferred, tax-exempt, or taxable account. Let’s take a look at each of these a little more in-depth.
A tax-deferred account is an account in which the securities contributed accumulate tax-free and are only taxed upon distribution. Key examples of tax-deferred accounts are a traditional IRA, 401(k) or another workplace account, and deferred annuities.
A tax-exempt account doesn’t offer a tax benefit on contribution, rather, all contributions are made with after-tax dollars and the distributions remain tax-free. The two most common tax-exempt accounts are Roth IRA and Roth 401(k).
A taxable account simply means that the investor must pay taxes on any investment income in the year it was received. Prime examples are investment accounts, brokerage accounts, high-interest savings account, and other bank accounts. While taxable accounts come with some flexibility, most interest and dividends are taxable immediately and gains are taxable at capital gains rates when the assets are sold.
The first step is to have an understanding of how these accounts are taxed in order to give a better indication of where your different securities can best thrive. The next step is to have an idea for the tax-efficiency of each security.
Securities through the eye of taxes
The tax-efficiency of each security will help reveal how the security will be taxed and which type of account will help give it the best return over time. This is just a general overview of securities, please make an appointment to discuss your particular situation. We are going to discuss three of the main assets you will come across along with their relative tax-efficiency.
The first being individual stocks. In general, these assets are often quite tax-efficient, especially when held for at least one year because this allows for long-term capital gains tax whose tax percentage is lower than most ordinary income tax rates. Your particular tax bracket is indicative of the percentage of capital gains tax you will pay.
Bonds, on the other hand, often fall into the tax-inefficient category namely due to the fact that the interest payments they accrue are taxed at the ordinary income rate. As a rule of thumb, the more tax-inefficient an asset is, the more money you will pay on it each year if it is held in a taxable account.
The last types of accounts we are going to look at today are mutual funds and ETFs which can be both tax-efficient and inefficient. ETFs are often tax-efficient but their downfall can be the turnover rate, delivering short-term capital gains which are taxed at a higher rate. Volatility is the main factor that can contribute to making mutual funds and ETFs fall back and forth on the efficiency scale.
Remember, these are generalizations to help you think about the way that your assets are viewed from a tax perspective. It is important to work with a professional to develop a unique strategy for your investment goals.
Which security goes where?
Now that you have an idea of the type of accounts available to you and the general tax-efficiency level of each security, it is time to get to the fun part: determining which securities to put in each account. Today, we are going to talk about a couple of strategies that could help.
The first is to place the most tax-efficient assets in taxable accounts. This could include municipal securities and municipal mutual funds, ETFs, as well as tax-managed mutual funds and other managed accounts.
The second strategy is to place the most tax-inefficient assets in tax-deferred or tax-exempt accounts. High turnover stock, for example, would be best suited in a 401(k) or IRA since they don’t trigger taxes while housed inside the account. The same holds true for taxable bonds and corporate bonds. Real Estate Investment Trusts are another asset that makes sense in this type of account.
The bottom line
Asset location can be an important part of your investment strategy. Understanding how your investments are taxed can help maximize your return. Each person’s investing needs will be different. Be sure that you work with your financial advisor to help create a plan that will work best for you and your goals.
Here at Step by Step, proactive tax planning is an integral component of what we do. Taxes impact your financial strategy in an important way and we want to ensure that you are empowered to make smart, confident choices with your financial future. Give us a call to learn more. We can’t wait to hear from you!