Benjamin Franklin was right on the money (pun intended) when he said the only guarantees in life are death and taxes.
As frustrating as taxes are, especially after you retire, there is a way to make them lighter using asset location.
If you don’t know much about asset location, it is probably because it is so esoteric many financial advisors don’t even bother with it. Instead, they focus on asset allocation.
While that is important, a large part of your returns could be wiped out if you don’t use asset location effectively. So, if you don’t want your taxes to eat into your hard-earned investments, here’s what you need to know about asset location.
What is asset location and why is it important?
Asset location is a strategy for minimizing your lifetime taxes by knowing which investments to put in a taxable, tax-deferred or tax-free account.
By just looking at those options, you might say that you want all of your investments in a tax-free account, but unfortunately, it is not that simple. For starters, every type of account has its advantages, disadvantages, and restrictions set by the government.
The key to maximizing these different accounts depends mainly on your asset allocation. Asset allocation simply means what you will be investing your overall portfolio in.
Now my overall philosophy for asset allocation is that you should spread your investments in different types of stocks and bonds, in the US and outside of it, in large, medium, and small sized companies. If you do this, you can reduce vulnerability to market declines that only hit one country or one portion of the stock market, while still putting yourself in a position to gain for the economic advancements that pass their way onto the capital markets. Needless to say, this is extremely important to have in place when you retire.
Once you establish where you want to invest (asset allocation) you need to decide where each investment will go (asset location). And again, the three choices we have for asset location are taxable, tax-deferred, and tax-free.
While this is not an exact science, and as with all things, this is dependent on your personal circumstances, there are a few rules of thumb that can help you make wiser decisions.
How to Make the Most of Asset Location
- Maximize the difference between your ordinary income rate and the capital gains rate
We all want our money in tax advantaged accounts. But before you rush off to place all of your investments in a tax-free account like a Roth, you need to understand your taxes and how each investment account is taxed.
Taxable accounts have no tax advantage, which means your capital gains and dividends will be subject to taxes. However, stocks you have held for longer than a year will fall under long term capital gains rate, which could be taxed at 0%, 15% or 20% depending on your tax bracket. Qualified dividends also fall under the capital gains rates as well.
For a tax-deferred account, such as your 401(k) or traditional IRA, your earnings and distributions are not taxed on a yearly basis. Instead, all of your distributions are taxed as ordinary income, which can be as high as 37%.
A tax-free account like Roth IRA, only consists of money you invested after paying taxes, so your returns are not taxed (as long as you follow all the applicable rules).
As you can see, the type of account you use will depend largely on your income bracket.
So, if your income is in 22% or 24% bracket, and you want to hold stocks for longer than a year, then it will be tax-efficient to put them in a taxable account, where the capital gains rate won’t be more than 15%.
If you put it in a tax-deferred account, you would have to pay your ordinary income rate (either 22% or 24% in this example) when you sell the stocks.
- Tax-inefficient investments are usually best in tax-advantaged accounts
Tax inefficient investments such as bonds, real estate investment trusts (REITs), actively managed mutual funds are usually best in tax-deferred accounts. As these investments provide regular income every year, they would be taxed at the ordinary income level if they were in a taxable account.
But in a tax-deferred account you can keep getting income from dividends and capital gains and they will only be taxed when you are ready to withdraw the money.
Another reason why bonds go well in tax-deferred accounts is that, unlike stocks, they grow slowly and yield lower RMDs (Required Minimum Distributions).
Once you reach the age of 72, you have to start taking some money out of your 401(k) or traditional IRA, or face steep penalties. So if you want bonds in your portfolio to lower the volatility that you experience, it could make a lot of sense to keep your bonds in your tax deferred accounts.
- Tax-efficient investments are usually best in taxable accounts
Again, there are no absolutes when it comes to asset location, but the general rule of thumb is you should put tax-efficient investments in taxable accounts.
Investments that don’t pay dividends or distribute capital gains are considered tax-efficient because they are taxed with the long-term capital gains rate instead of the ordinary income rate. Of course, this is only the case if you hold the investment for longer than a year.
Besides paying less in taxes, you also won’t have any problems with RMDs, which are only a problem for tax-deferred accounts.
- Consider the tax implications for your heirs
As great as tax-deferred accounts can be for you, they are not so kind to heirs. Whoever takes over the account will have to pay ordinary income when they distribute it.
On the other hand, taxable accounts will be passed to heirs tax free because of the step up in basis that taxable accounts have.
A Roth IRA is also tax-free for heirs to some extent. If the account has been held for at least five years, then the beneficiary won’t pay taxes on it. I should mention that the heir might be subject to distribute the account in a certain period of time, depending on their relationship to the owner.
- Put your high growth, high potential investments in tax free accounts
I am sure all of you have heard of Paypal, the payment processing company that was co-founded by Peter Theil. This story is a great illustration of how to use your Roth IRA.
Back when Paypal was just getting started, Peter’s income was low enough to contribute to his Roth IRA, and in 1999 he purchased 1.7 million shares of his startup company for $1,700 total. Since then, Paypal has become an enormously successful company, and Peter was able to sell his shares in Paypal, and use his Roth IRA to invest in other high growth, high potential companies without worrying that his gains would be subject to annual taxation. After doing this successfully multiple times, there was a report a few years ago that Peter had over $5 billion in his Roth IRA!
Now even if we aren’t going to end up with $5 billion in our Roth accounts, the story is still helpful: The Roth IRA is a great spot to hold your investments that are the most likely to grow, especially over your 30 year investment time horizon.
Because we know that your distributions, when following the proper rules, will not be taxed. And we know that your beneficiaries will not have to pay taxes on it as well (agian, if you follow the 5 year rule mentioned above).
So if you’ve got something with a lot of growth potential, you should consider your tax free accounts as a great place to hold that investment.
wrapping it up
If there was a way to summarize how asset location works, it would be that the more tax-efficient an investment is, the less tax protection it needs.
However, this depends on a few factors such as your current income bracket and if you plan on leaving an inheritance, and to whom that inheritance is going toward.
While I’ve tried to make it look straightforward on paper, asset location is something you need to discuss with your financial adviser, because your taxes and personal circumstances do vary so much.
Also, please remember: Asset allocation and asset location go hand in hand, and both need to be a part of your retirement plan.
If you want to see how this fits in with your overall retirement plan, go to startmyretirement.us and we will create a free one-page retirement plan for you that discusses both of these important subjects.