Most of us have heard of asset allocation – the process of dividing a portfolio’s assets across various parts of the market according to an investment plan that takes into account an investors goals and risk tolerance. Asset location, on the other hand, is a tax minimization strategy that takes into account how different types of investment returns are taxed based on what type of account they reside in.
First, some basics on taxes and investing. The return of an investment portfolio with a mix of stocks and bonds will be comprised of three different elements: interest, dividends and capital gains. Added together, they make up what is known as “total return”.
Inside an IRA or other tax-deferred accounts, the relative mix of investment return does not matter. A 5% return is a 5% return, regardless of whether it comes from interest, dividends or capital gains. That is because withdrawals are all taxed the same – at your ordinary income tax rate.
However, in a taxable investment account, each type of investment return is taxed differently. Interest income and short-term capital gains are taxed when earned at a taxpayer’s “ordinary” income tax rate, while qualified dividends and long-term capital gains are generally taxed when earned or realized, but at a lower, preferential rate. No taxes are paid on unrealized gains until an investment is sold.
Based on this, we can, therefore, develop some asset location principles:
- The source of return for stocks is dividends and capital gains, both of which receive favorable tax treatment. In addition, unrealized capital gains on individual stocks and low turnover stock mutual funds can defer taxes indefinitely. Therefore, stocks and stock funds should generally be located in taxable accounts.
- Bonds, on the other hand, derive their return from interest income, which is subject to higher ordinary income tax rates. Therefore, bonds should generally be located in tax-deferred accounts.
- Tax-free investments, such as municipal bonds, generally are characterized by a lower but tax-exempt interest rate. Therefore, tax-free investments should only be located in taxable accounts.
- Treasury Inflation Protected Securities (TIPS), are especially tax inefficient, because any inflation adjustment to the principal value is subject to tax in the year it occurs, even though the benefit from the increase is not realized until the bond is sold. Therefore, TIPs should be located in tax-deferred accounts.
- Real estate investment trusts (REITs) must distribute a high level of current dividend income to maintain their tax preference status at the trust level, which on average produces a higher level of taxable income to the REIT holder on a year to year basis. REITs, therefore, should be located in tax-deferred accounts when possible.
- Mutual funds that are managed for tax sensitivity should only be located in taxable accounts.
In our portfolio design, when it is appropriate, we incorporate these asset location principles as they can produce significant tax savings over time. We believe doing so will produce higher after-tax returns in our client portfolios, which in turn will bring you closer to reaching your financial goals.