Protecting your assets
Minimize Taxes with Asset Location
Asset location is a tax-minimization strategy that takes advantage of different types of investments getting different tax treatments. Using this strategy, an investor determines which securities should be held in tax-deferred accounts and which in taxable accounts to maximize after-tax returns. Who can benefit from this investment strategy, how can asset location minimize taxes, and what's the optimal way to locate assets?
Asset location, although it provides for lower taxes, is not a replacement for asset allocation, which is positioning equities, funds, and other holdings in a portfolio across different sectors to cushion market downturns. Only after you determine the proper asset mix for your portfolio can you position those investments in the appropriate accounts to minimize taxes.
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, real estate investment trusts (REITs) and the related mutual funds should be held in tax-deferred accounts, as should any mutual funds that generate high yearly capital gains distributions.
To benefit from this strategy, investors must have investments in both taxable and tax-deferred accounts. Typically, investors who use a balanced investment strategy consisting of equity and fixed-income investments can get the most benefit from asset location. Investors with all fixed-income or all-equity portfolios can still benefit, but not to the same degree.
A typical investor with a balanced portfolio consisting of 60% stocks and 40% bonds might hold investments in both taxable accounts and tax-deferred accounts. Although the investor's 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.
For example, an investor with an asset mix of 40% fixed-income and 60% equity will achieve the maximum benefit if the tax-deferred account holds 40% and the taxable accounts holds 60% of the total assets. In this case, moving all fixed-income investments into the nontaxable account and all equities into the taxable account will provide the maximum benefit.
If an investor is withdrawing funds from tax-deferred accounts or will be doing so soon, the benefit of asset location is greater than for younger investors with many years left before they start withdrawing funds.
Assume an investor has accumulated $20,000 in capital gains and dividends in a traditional individual retirement account (IRA). The investor takes the full amount as a distribution, which is then treated as ordinary income. If the taxpayer falls in the 35% tax bracket, the investor would be left with $13,000. If the investor made $20,000 in long-term capital gains and qualified dividends in a taxable account, the tax would have been only 15%, leaving $17,000.
How a security is taxed will determine where it should be located.
How a security is taxed will determine where it should be located. Long-term capital gains and qualified dividends are given favorable rates of 0%, 15% or 20%, depending on your income level. Meanwhile, taxable interest is reported on Form 1040 and is subject to ordinary income rates, which range between 10% and 37%.
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 37%) if withdrawn from a traditional IRA, 401(k), 403(b), or another type of retirement account where taxes are paid on the withdrawal of funds.
Fixed-income investments such as bonds generate a regular cash flow. These interest payments are subject to the same ordinary income tax rates of up to 37%.
Asset location determines the proper account in which to place investments for the most favorable overall tax treatment. The best location for a particular security depends on an investor's financial profile, prevailing tax laws, investment holding periods, and the tax and return characteristics of the underlying securities.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.