If you have been investing for any length of time you have probably accumulated investments in multiple different accounts. If you’re like the average American you have a 401(k) through your employer, a Traditional IRA (probably rolled over from a previous employer), and hopefully a Roth IRA and a Taxable Brokerage account (individual or joint). For this article I’m going to assume you know the major differences between these accounts and how they are taxed and instead focus on the actual investments held in these accounts. Just by being selective and choosing which type of investments you hold in each account has the potential to save you thousands in taxes! I’m talking about Asset Location strategies.
Asset location, simply put, is selectively choosing which investments best fit which account. This is very different from the similar sounding "asset allocation". Asset allocation deals with the amount of each different asset (stocks, bonds, gold, real estate, etc.) that you should hold in your overall portfolio. Asset location is choosing where to hold the stocks, bonds, real estate, etc.
Breaking Down Your Portfolio
Start by looking at all the investments in your total portfolio. You probably hold some bonds, some large cap stock funds, some small cap funds, and some international funds. Where is the best place to hold each of these different investments? Well, let’s start with the bonds.
Tax-Efficiency of Bonds
Bonds are generally tax in-efficient. This is because the majority of the return comes from the income they generate in the form of interest payments. While this income is great for a retiree on a fixed income, it is not so great from a tax perspective. That’s because this income is taxed at ordinary income tax rates. Therefore, if you are in a higher tax bracket you are going to be paying a lot more tax on this income when compared to your capital gains. Junk bonds are the most tax in-efficient because they pay more interest to compensate the investor for the credit risk of the issuing company. Due to these tax characteristics, a tax-deferred account such as a Traditional IRA or 401(k) might be a good place to hold them. In these accounts you are sheltered from the income tax on the interest earned. The exception to this is municipal bonds, which earn tax-free interest and therefore should always be held in a taxable account. Two other exceptions to the rule would be when interest rates are low or when your income is low. If you are in a low tax bracket that’s comparable to your long-term capital gains tax rates, then you could just as well hold the bonds in your taxable account. Also, when interest rates are very low, you won’t be receiving much in the way of income so there again the tax protection of a tax-deferred account isn’t as valuable.
Tax-Efficiency of Stocks
Unlike bonds, the majority of your profit in stocks is going to come from price appreciation, although you also have to be aware of the dividend income from stocks, especially large cap value stocks. When looking at stocks you should try to categorize them into U.S. and international stocks and then further break them down into large cap and small cap stocks and value and growth (or core) stocks. Historical return numbers show that small cap stocks and value stocks tend to outperform over time. This means that you should protect yourself from the increased capital gains by holding your small cap stocks and value stocks (or better yet, your small cap value stocks) in your tax-free accounts like your Roth IRA. Inversely, large cap stocks tend to be slower growers than their small cap counterparts, so they could be held in a taxable account, as they still receive favorable capital gains tax rates (when held for over a year). Just remember those large value stocks historically have paid the highest dividends so those might be better suited to a tax-deferred account.
Are you starting to get the hang of it? The whole idea is to think about the return characteristics of each stock category and then place it in the best account to protect yourself as much as possible from the taxes. One more thing to consider is whether or not you are going to be actively trading a particular investment. If that’s the case, you should try to do so in a tax-deferred account so your capital gains are not taxed at the higher short-term capital gains rates.
There you have it. Asset location is another strategy in your arsenal you can use it to increase your after-tax rate of return. Keep in mind that all of these strategies may be different depending on your individual tax situation. This is because your tax rates may differ depending on your income and therefore the value of the tax protection will differ.Phillip Christenson, CFA is a financial advisor and co-owner of Phillip James Financial, a fee-only financial planning company located in Minnesota. He also operates the affiliated tax practice PJF Tax, which provides tax planning and tax preparation services for wealth management clients.