Asset Location Drives After-Tax Investment Returns

After-tax investment returns are what matter, but few investors take a key step that could minimize the taxes on their portfolio returns. Research from the Schwab Center for Financial Research, Morningstar, AQR Research, and others shows that taxes are one of the main determinants of an investor’s bottom line.

A major factor in increasing after-tax returns is to have assets in the right accounts. In other words, maximize after-tax returns by first choosing your investments and then optimizing asset location. Most investors have several types of accounts, each of which has different tax effects. Taxable accounts are regular accounts at brokers and mutual funds. Interest and short-term capital gains earned in these accounts are taxed as ordinary income in the year they are earned.

Long-term capital gains (gains on assets held more than one year) and qualified dividends have maximum tax rates of 20% and lower tax rates for taxpayers not in the top tax brackets. Interest earned on state and local government bonds and some other types of income are tax free in taxable accounts. Tax-deferred accounts include IRAs, 401(k)s, annuities, and some other types of accounts.

All investment earnings in these accounts compound tax- free within the accounts but are taxed as ordinary income when distributed. Tax-free accounts include Roth IRAs, and health savings accounts.

The investment earnings compound tax- free in these accounts and are tax-free when distributed. You maximize after-tax returns by holding assets in the most tax-efficient account for them, to the extent that it’s practical. The priority is choosing the right asset allocation for you.

Then, to the extent you can based on how much money you have in each of the different accounts, hold each investment in the type of account that’s optimum for it. But don’t change your investment choices simply because you can’t own an asset in the optimum account. The general rules for optimum asset location are simple, but there are important exceptions that can enhance your after-tax returns.

The first general rule is that investments that have their own tax advantages should be held in taxable accounts. Bonds that generate tax-free interest should be in taxable accounts.

Qualified dividends, which are dividends paid on most stocks of U.S.-based companies, have the tax advantage of a maximum 20% tax rate. Master limited partnerships usually are best held in taxable accounts, because they have their own tax benefits and their earnings might be taxable when they’re held in IRAs.

Often stocks, exchange-traded funds and mutual funds should be held in taxable accounts when possible, be- cause they earn long-term capital gains taxed at the maximum 20% rate when held for at least one year. In addition, when they’re held in taxable accounts, losses can be deducted against other capital gains, and up to $3,000 of capital losses that exceed capital gains for the year can be deducted against other types of income.

Tax-deferred accounts should hold investments that generate ordinary income in taxable accounts. When the earnings are distributed from the tax-deferred account, they’re taxed as ordinary income anyway. But while they’re in the tax-deferred account, they compound tax-deferred to a higher amount than if they were in a taxable account.

When assets that can generate qualified dividends or long-term capital gains are held in a tax-deferred account, that effectively converts a tax-advantaged investment return into ordinary income. That’s because all distributions from tax-deferred accounts are taxed as ordinary income, even if they would be tax-favored long-term capital gains or preferred dividends in a taxable account.

In tax-free accounts, such as Roth IRAs, the optimum investments are those with the highest returns in your portfolio. Distributions from the accounts are tax free and the earnings compound tax free within the account. You maximize tax-free income by having the highest-returning investments in the tax-free account.

Let’s look at some exceptions to these general rules. While the general rule is to hold stocks and stock mutual funds in taxable accounts, because they already have favorable tax treatment in taxable accounts, that’s not always the optimum choice.

These assets are best held in taxable accounts when you will hold them for more than one year, so gains are long- term capital gains. When you are likely to sell a significant portion of them before one year, the gains are taxed as ordinary income anyway. It’s better to shelter them in a tax-deferred account so they compound to a higher level before being distributed and taxed as ordinary income. In a taxable account, the short-term gains would be taxed each year, so they would compound to a lower amount.

Also, some mutual funds distribute a significant portion of their gains each year. Such funds are best held in tax-deferred accounts. The best fund choices for taxable accounts are index funds, most ETFs and mutual funds with low turnover ratios. Some researchers conclude that stocks and mutual funds are optimum for taxable accounts only if you hold them for years and their returns compound at a fairly high rate. More frequent buying and selling tilts the choice in favor of tax-deferred and tax- free accounts.

My research over the years shows that when pre-tax returns from stocks or other investments are significantly higher than returns from other in- vestments, you’re better off in the long term by holding the higher-returning assets in a tax-deferred account than a taxable account. The compounding of the higher returns is more important over the long term than the tax benefits of the taxable account.

In recent years, when interest rates have been very low, there hasn’t been much advantage to holding interest-earning investments in tax-deferred accounts. It has been better to put the highest-returning assets in tax-favored accounts and put the very low-earning investments in taxable accounts.

My research indicates the tipping point is when stock returns exceed returns of income investments by more than four percentage points.

At that point, after-tax returns often are optimized by having the stock returns compound in a tax-deferred account. It is also important to keep in mind that the ordinary income tax rate when assets are put in a tax-deferred account might not be the same as when returns are distributed from the tax-deferred account.

Someone who is in the highest income tax bracket during the working years might be in a lower tax bracket after retiring. When you’ll be in a lower tax bracket in retirement, the optimum strategy can be to put higher-returning assets in tax-deferred accounts during the accumulation years.

As mentioned earlier, your high- est-earning investments should be held in tax-free accounts, such as Roth IRAs, whenever possible. Of course, the overall asset allocation is the dominant consideration. Once that decision is made, try to own the investments in the accounts that maximize after-tax returns to the extent possible.