Many investors aim to diversify their customers’ financial portfolios among different asset categories such as stocks, cash, bonds, index funds and other investment vehicles. The practice of asset allocation is common among financial advisors and serves to reduce financial risks by balancing potentially volatile, high-return assets with more stable and potentially lower-return assets.
Being a wealth advisor, I agree that asset allocation is the most important part of any investment strategy. However, also an important but often overlooked practice among investors is asset location. Simply put, different types of investment accounts receive different tax treatment. The type of accounts where your assets are located can have a major impact on how much income you earn from investments, after tax.
So, the important question is, are you using your investment accounts to their greatest tax efficiency?
If you are investing for retirement, knowing the difference between a tax-deferred and taxable account and understanding what types of investment assets are best placed in which accounts are critical to maximizing your earnings over time.
Which account is best?
There are three main types of accounts: traditional IRA/401(k), Roth IRA/401(k) accounts, and taxable accounts. Unlike taxable accounts, a traditional IRA and 401(k) are tax-deferred and Roth IRA and Roth 401(k) are tax-exempt accounts.
Traditional IRA/401(k) accounts: It is best to place bonds and dividend stocks in traditional accounts because they generate income. One of the main benefits of this account is the ability to defer taxes on investment income. These assets also tend to grow at a lower rate of return. Why does this matter? You must start taking required minimum distributions (RMDs) from this account once you turn 72 (or 73 if you reached age 72 after Dec. 31, 2022 ) and these RMDs will be taxed at ordinary income tax rates. Therefore, by putting assets that tend to grow slower, your RMDs will be lower.
Roth IRA/401(k) accounts: This type of account is a great place for your stocks because you want it to grow as much as possible. The more it grows, the bigger your tax savings. The benefit is that there is no tax upon withdrawal.
Taxable accounts: Taxable accounts are a good place for stocks because they don’t generate as much income as bonds typically do. Investment earnings in this account (capital gains, interest and dividends) are taxed each year. The reason stocks are better is because of the growth that they have as well as the lower tax rate typical for capital gains compared to income tax. Tax-efficient funds (e.g. municipal bond funds) or funds that generate little to no dividend income (e.g. ETF, index funds) should be held in taxable accounts.
For an example of how this works, consider someone who has $250,000 in a taxable bond fund for 20 years. The person pays a 35.8% marginal income tax rate and the bond earns 6% rate of return each year before taxes. At the end of 20 years, the difference between a taxable account and an IRA could be nearly $72,000 in favor of the IRA.
Following is an example of how the Roth IRA/401(k) can be a benefit. If someone age 35 contributes $6,000 each year, at an 8% return and with a marginal tax rate of 25%, they would contribute $180,000 over that time frame. At age 65, the Roth IRA would be worth $734,075. If monies were held in a taxable account, they would only be worth $502,810.
Trade-offs
One of the difficulties is you can’t always be perfectly tax efficient because it depends on what your asset allocation between stocks and bonds is and how much you have saved in each type of account. You do not want to change an asset allocation that has been working for you just to make the accounts more tax efficient.
Another thing to note is frequency of trading. If you enjoy trading and do it several times a year, avoid doing so in your taxable account. Instead, trade in your IRA or 401(k) accounts where you will not be generating capital gain taxes. Your investment holding period can determine how much benefit you get from an asset location strategy. How long you keep your assets invested matters. The longer time period allows for more gain from these strategies because it saves on taxes each year. Essentially, managing your asset location is a delicate balancing act.
Conclusion
As with diversifying your assets, diversifying your asset location is also key. Working with a financial advisor and accountant to spread money around in the different accounts can help you better manage taxes and determine the amount of income you have each year.
There are a lot of nuances in determining the best strategy because your life goals, investment holding period, current life stage and prevailing tax laws will affect the overall distribution of your asset locations. While it is advisable to consult with a financial advisor to earn the maximum benefit from your investment portfolio, having a basic understanding of the different types of accounts as well as how your assets are taxed are both also important in securing a healthy financial future.