How much time do you spend on asset location? Notice, that’s asset location not asset allocation.
If you’re like most investors and even financial advisers, you don’t give asset location much time or attention or use some oversimplified rules of thumb. Over time, that oversight reduces after-tax returns, and that means your nest egg won’t last as long.
By asset location, I mean the type of account in which an asset is held. Most people have three types of accounts. Taxable accounts are standard brokerage or mutual fund accounts with no tax benefits. Tax-deferred accounts are traditional IRAs and 401(k)s, annuities and even life insurance cash value accounts. Income and gains in these accounts compound tax-deferred but are taxed when distributed. Tax-free accounts are Roth IRAs and 529 college savings plans. Income and gains compound free of tax and usually are tax free when distributed.
Most of the investors who do consider asset location often follow the rules of thumb that stocks should be owned in taxable accounts, while bonds and other income investments should be in tax-advantaged accounts. Those rules of thumb are true in many cases, but like many rules of thumb there is more to the story and key exceptions. Many people will lose substantial after-tax wealth over their lifetimes by blindly following the rules of thumb instead of considering their own situations.
It is important to realize the trade-offs of tax-deferred accounts. The good feature of these accounts is the tax deferral. Income and gains compound each year without being reduced by taxes.
The downside of tax-deferred accounts is distributions are taxed as ordinary income. The accounts can convert tax-advantaged income, such as long-term capital gains and qualified dividends, into ordinary income taxed at the highest individual rates. When the asset location isn’t optimal, a tax-deferred account might deliver less after-tax money than the same assets would have compounded to in a taxable account.
Optimizing your asset location, or even improving it a bit, can boost your after-tax wealth.
Before we dive into the research results, I want to make clear that having the right asset allocation is more important than having the optimum asset location. You want the right asset mix for you, even if that means holding some investments in the “wrong” accounts. Not everyone has money spread among the different accounts in the right proportions to achieve optimum asset location. Decide which assets you want to own first, and then match them as best you can to the accounts you have.
Let’s look first at some general rules for asset location.
• Assets that have no tax advantages generally should be held in tax-deferred or tax-free accounts when possible. Any asset that generates ordinary income falls into this category.
The income is taxed as ordinary income regardless of the account that holds it. But the income will compound in the tax-deferred account until distributed, and the compounding should give you more after-tax income than if you paid taxes on the income each year. Of course, if the investments are held in a tax-free account such as a Roth IRA, the income never is taxed and you have even more after-tax wealth.
Assets without tax advantages are those that pay taxable ordinary interest. Treasury bonds, money market funds and high-yield bonds are the prime candidates.
Real estate investment trusts (REITs) usually fall into this category. Their dividends aren’t qualified dividends with the maximum 20% tax rate. Instead, they are taxed the same as ordinary interest. This was more important in years past when REITs had yields of 4% and higher. Now, REIT yields are much lower. If you plan to own them for the long term and eventually sell for substantial long-term capital gains, it might be better to own them in taxable accounts.
Stocks and stock mutual funds you hold for one year or less also are best owned through tax-advantaged accounts.
• Investments with their own tax advantages usually should be held in taxable accounts
Stocks and stock mutual funds that you plan to hold for more than one year qualify for long-term capital gains and are the obvious candidates for taxable accounts.
Stocks with high dividend yields often are best held in taxable accounts when the dividends are “qualified dividends” subject to a maximum 20% tax rate. Most dividends paid by U.S. corporations are qualified dividends.
Now, let’s examine some situations in which the general rules aren’t the best advice. My number crunching over the years revealed that details determine when stocks, whether purchased individually or through mutual funds, should be in a taxable or tax-advantaged account. Research by others agrees.
Mutual funds require the most analysis, even if you’re planning to own the funds for more than one year.
A mutual fund distributes most of its net gains and income to shareholders by the end of each year. They are included in your gross income, even if you choose to have the distributions reinvested. A mutual fund that does a lot of trading during the year can distribute a substantial portion of its appreciation to shareholders. Long-term gains and qualified dividends earned by a fund are taxed that way to shareholders, but short-term gains distributed by a fund are ordinary income to the shareholder.
The result is you might hold a stock fund for the long-term but a good portion of the appreciation will be taxed to you each year, and even might be taxed as ordinary income.
The general rule is a good one when your stock mutual funds or your stock portfolio are tax efficient. When you own mutual funds that make low annual distributions and you don’t take gains on your mutual funds or stocks after holding them less than a year, the stocks and stock mutual funds should be in a taxable account.
But if you own stock mutual funds that often make distributions equal to 20% or more of their annual returns, consider owning them in a tax-advantaged account, especially if the distributions tend to be taxed as ordinary income. For example, if a fund returns 10% for the year and distributions are 4% or more of its net asset value, it is not tax efficient and is best owned through a tax-advantaged account.
There are two other factors to consider.
One factor is the difference between the rates of return on different investments. It usually is advantageous to hold the higher returning investments in a tax-advantaged account when there is a difference of five percentage points or more in the annual returns, even when the higher-returning investments are tax advantaged. This is especially true when you anticipate leaving the investments in the tax-advantaged accounts for a decade or more so the higher returns can compound.
The conventional wisdom is really turned on its head when Roth IRAs and other taxfree accounts are considered. When you are able to earn significantly higher returns from stocks or other investments, you’ll have more lifetime after-tax income when those gains compound tax-free in the Roth IRA and then are tax-free when distributed. Unless you’re a very tax efficient investor, (an annual tax rate on your investment returns of 5% or so) or there’s not much of a difference between returns on your different investments, it’s often better to hold the low-returning, ordinary income investments such as bonds in taxable accounts. The longer the compounding period, the more valuable the tax-free account is.
The second factor is the difference between your tax rates. When you are in the highest income tax bracket, then getting the location allocation right can save substantial tax dollars over your lifetime. But when you’re in the middle or lower brackets and there isn’t as big a difference between the ordinary income tax rate and long-term capital gains rate, you’ll still be better off with the optimal asset location, but you won’t reap as much reward as a high-bracket investor.
There are two long-term factors that merit some consideration.
When you plan to hold an appreciating investment for life, it makes sense to hold it in a taxable account. Your heirs will inherit it and immediately increase the tax basis to current fair market value. They can sell it and not owe any taxes on the appreciation that occurred during your lifetime. They don’t have that advantage in a tax-deferred account.
Also, consider your future tax rate if you think it can be anticipated. The penalty for holding the wrong investments in a traditional IRA or similar account isn’t as high if you’re in a high tax bracket today but expect to be in a lower bracket when taking distributions.
Of course, once you decide to own an investment in a taxable account, you should try to manage that account as tax efficiently as you can. We discuss strategies for doing that in this month’s Tax Watch article.
Remember, owning the right assets is the most important decision. But when your nest egg is spread among different types of accounts, it makes sense to try to optimize the location of your investments.