Asset location is a tax management technique where an investor places the most tax-efficient investments in the least tax-efficient account type and vice versa to reduce near-term taxes. Both asset allocation and asset location are important considerations when building an investment portfolio to meet a client’s specific goals. In essence, asset allocation is what investments are in the portfolio and asset location is where those assets are located.
A typical investor with a portfolio consisting of 60% stocks and 40% bonds might hold investments in both taxable and tax-deferred accounts. Although the overall portfolio should be balanced, each account does not need to have the same asset mix. Creating the same asset allocation in each account ignores the tax benefit of properly placing securities in the type of account that will assure the best after-tax return.
How security is taxed will determine where it should be located. Under the 2010 tax code, dividends and capital gains get favorable treatment. While interest income gets taxed at a 35% rate for investors in the highest tax bracket, the tax rate for dividends and capital gains is only 15%. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account. Those same capital gains and dividends, however, would be taxed at the ordinary rate (up to 35%) if withdrawn from a traditional IRA, 401(k), 403(b), or other type of retirement account where taxes are paid on the withdrawal of funds.
The best location for an investor’s assets depends on a number of different factors including financial profile, prevailing tax laws, investment holding periods, and the tax and return characteristics of the underlying securities.
Tax-friendly stocks should be held in taxable accounts because of their lower capital gains and dividend tax rates and the ability to defer gains. Riskier and more volatile investments belong in taxable accounts both because of the ability to defer taxes and the ability to capture tax losses on poorly performing investments sold at a recognized loss. Index funds, as well as exchange-traded funds (ETFs), are valued for their tax efficiency and should also be held in taxable accounts, as should tax-free or tax-deferred bonds.
Taxable bonds, REITs and the related mutual funds should be held in tax-deferred accounts. Any mutual funds that generate high yearly capital gains distributions also belong in tax-deferred accounts.
Asset location helps determine the proper account to place investments in to get the most favorable tax treatment. It is not a replacement for asset allocation, but complements the overall after-tax return. The best location for particular security depends on an investor’s financial profile, existent tax laws, investment holding periods, and the tax and return characteristics of the underlying securities.
