In the complex world of personal finance, asset location It’s a hidden strategy that smart investors use to gain a distinct advantage. Most people know to spread their investments across different asset types to create a proper asset allocation. But not everyone has an asset placement strategy. This means consciously allocating funds to various tax treatments.
What is asset location?
When asset allocation establishes an investment mix across asset classes, asset placement involves placing assets in taxable, tax-deferred, and tax-exempt accounts to minimize taxes and maximize the portfolio’s after-tax returns. It involves the distribution of certain assets between
It has the potential to improve your portfolio’s performance and minimize your tax liability. At a time when smart financial decisions are paramount to achieving financial goals, understanding where your assets lie is an important tool for all investors.
Allocating assets strategically can help you:
- reduce your overall tax bill
- Increase in after-tax returns
- Accelerate your path to financial independence.
Understand the tax treatment of your account
Different types of accounts have different tax treatment. Taxable accounts, tax-deferred accounts, and tax-free accounts can be thought of as three “tax buckets”.
- taxable account: Taxable accounts are typically securities trading, investment, or other accounts that do not have special tax benefits.
- Money deposited into a taxable account is after-tax money. After-tax money is money that has already been taxed and the rest is money available for spending or saving.
- You also pay taxes as you grow. The interest and dividends your funds generate, and any capital gains you realize, are taxed in the year they occur.
- Interest, nonqualified (ordinary) dividends, and short-term capital gains are taxed at ordinary income tax rates, and realized long-term capital gains and qualified dividends are taxed at preferential rates.
- tax deferred account: Tax-deferred accounts include traditional IRAs, 401(k)s, and more. These savings vehicles provide immediate tax benefits.
- They are funded with pre-tax funds. You can invest your earnings without paying taxes.
- Growth is tax deferred. This means you only pay taxes when you withdraw your money.
- tax exempt account: Tax-exempt accounts include Roth IRAs, Roth 401ks, etc. These accounts provide future tax benefits.
- They are funded with after-tax money, that is, money you pay taxes on.
- Neither growth nor qualified distributions are taxed.
Asset location guidelines and strategy
Asset location strategy involves strategically placing specific investments in different types of accounts (taxable, tax-deferred, or tax-free) to maximize after-tax returns and minimize overall tax burden. Includes:
Here are some considerations.
Invest tax-efficient assets in taxable accounts
A tax-efficient asset is an investment or financial instrument that is structured or managed in a manner that minimizes the tax burden associated with it. These assets are designed to generate income, capital gains, and other benefits while reducing tax consequences, allowing investors to keep more of their earnings.
Tax-efficient assets are especially important for individuals who want to maximize their after-tax profits and minimize their tax burden. Common examples of tax-efficient assets include:
The following tax-efficient investments are generally suitable for taxable accounts.
- tax exempt local bonds: Exempt from federal and, in some cases, state taxes.
- Index funds and ETFs (exchange traded funds): Stock turnover is generally low and capital gain distributions are minimal. Most of their returns come from price appreciation and are not taxed until the fund is sold.
- cash and cash equivalents: In a low interest rate environment, these investments typically provide minimal interest income that is subject to tax.
- Eligible dividend stocks: Hold qualified dividend stocks in a taxable account, as they often have a lower tax rate.
put Assets in tax-advantaged accounts are less tax efficient
The following investments generally have low tax burdens and are usually well placed in tax-advantaged accounts.
- Active management of stock funds: These funds generally have high turnover of stocks in the portfolio, some of which are short-term gains, because the fund manager actively buys and sells assets to achieve investment objectives, generating large taxable profits. , in which case they will be taxed at less favorable rates.
- Government bonds/corporate bond funds: Most of the income from these investments comes from interest (sometimes called dividend yield) and is taxed annually at ordinary income tax rates. Tax deferral helps you avoid paying ongoing income taxes on interest, allowing you to keep a large portion of your funds invested and growing within your account.
The location of your assets plays an important role in tax-efficient investing. By considering how different assets are taxed in different accounts, you can keep more of your investment income. If your goals, income, or tax bracket changes, evaluating and changing the location of your assets is a wise strategy.
Think strategically about how to use funds from taxable accounts
If you have taxable accounts in your investment portfolio, you may want to consider looking into some tax planning opportunities that could benefit you.
- Recovery of loss: Sell investments that have declined in value to realize a capital loss in your taxable account. These losses can be used to offset capital gains and reduce taxable income.
- Estate planning: When passing assets to your heirs, consider the potential increase in cost basis on taxable investments. This helps minimize capital gains tax liability for beneficiaries.
- Tax-efficient charitable donations: Consider donating appreciated assets from your taxable account to charity. This provides the dual benefit of tax deductions on donations and avoidance of capital gains taxes.learn about
Consider “moving”
Just as you can change your asset allocation, you can also change the location of your assets to optimize your taxes.
- ROther IRA conversions: Convert your funds from a traditional IRA to a Roth IRA over time. This includes paying taxes on the amount converted, but once in a Roth IRA, the assets grow tax-free and can be withdrawn tax-free in retirement. Be aware of the tax implications when performing conversions. Get different types of personalized conversion strategies with NewRetirement’s Roth Conversion Explorer.
- Tax-efficient withdrawals: If you’re retired or in low taxes, consider withdrawing money from tax-deferred accounts like traditional IRAs and 401(k)s before tapping into taxable accounts. This strategy will help you manage your overall tax bill.
- In-kind remittance: Transfer investments in-kind (without selling them) from one account to another. This is useful for moving tax-efficient assets into taxable accounts, or moving tax-inefficient assets into tax-advantaged accounts.
- Qualified Charity (QCD): If you are 70 1/2 years old or older and have an IRA, consider making charitable contributions directly from your IRA. QCDs can satisfy required minimum distributions (RMDs) and reduce your taxable income.
When considering investments, prioritize asset allocation over asset location.
Because the mix of stocks, bonds, and cash determines the majority of long-term investment returns, it’s important to keep asset allocation decisions a top priority. Asset placement focuses on tax efficiency and, while beneficial, the tax impact is secondary to asset allocation in terms of total return impact for the typical investor.
While asset allocation should be the primary focus, asset location can provide value, especially for large investment portfolios with multiple tax buckets as discussed above. You can further increase your after-tax returns by strategically placing your investments across taxable and tax-advantaged accounts. However, it is asset allocation, not location, that ultimately determines the direction of your overall investment strategy.
Always consider taxes as part of your overall financial plan
NewRetirement Planner helps you visualize where your assets are and strategize in a better way. This easy-to-use tool puts the power of planning, including tax visualization, in your hands.
Want to learn more about taxes? Check out our 12 tips for year-end tax filing.
