Asset Location: Minimize the tax drag on your investments


Let’s face it, no one likes to pay taxes. In fact, the President of the United States bragged that he didn’t pay any taxes at all.

So how do you reduce the amount of taxes that you pay on your investments?

Well, one way to minimize the tax drag on your investments is through asset location.

Asset location is a tax minimization strategy that takes advantage of the fact that different types of investments get different tax treatments.

In asset location, an investor determines which securities should be held in tax-deferred accounts and which securities should be held in taxable accounts. This is done in order to maximize after-tax returns.

In this article, I’ll explain who can benefit from this investment strategy, how asset location minimizes taxes and the optimal way to locate assets.

Asset Location: Who Benefits?

You must have investments in both taxable and tax-deferred accounts to benefit from this strategy.

Those investors with assets split between taxable and nontaxable accounts and with similar asset mixes will get the largest benefit from asset location.

If for instance you have an asset mix of 40% fixed income and 60% equity, you will achieve a maximum benefit if the tax-deferred account holds 40% and the taxable accounts holds 60% of total assets.

Moving all your fixed-income investments into the nontaxable account and all your equities into the taxable account will provides a maximum benefit.

In general, if you are an investor who uses a balanced investment strategy that consists of equity and fixed-income investments, you can get the most benefit from asset location.

This does not mean however, investors who have all fixed-income or all-equity portfolios don’t benefit. They will benefit, just not to the same degree.

If you are an older investor who is withdrawing funds from tax-deferred accounts or will be doing so soon, the benefit of an asset location strategy is greater than it would be for younger investors.

How Asset Location Minimizes Your Tax Liability

You might hold investments in both taxable accounts and tax-deferred accounts if you are  a typical investor with a balanced portfolio consisting of 60% stocks and 40% bonds.

While your overall portfolio should be balanced, each account does not need to have the same asset mix.

If you were to create the same asset allocation in each account, it would ignore the tax benefit of properly placing securities in the type of account that will assure the best after-tax return.

Therefore, you should know how a security is taxed as it will determine where it should be located.

Fixed-income investments, such as bonds and real estate investment trusts (REITs) generate a regular cash flow. Interest payments from these investments are subject to the same ordinary income tax rates of up to 35%.

A tax-deferred retirement account provides investors with a shelter for this income

How You Can Achieve Optimal Asset Location

Asset location, although it provides for lower taxes, is not a replacement for asset allocation.

Before you can locate investments in the appropriate accounts to minimize the tax drag, you must determine the proper asset mix for your portfolio. The best location for an investor's assets depends on several different factors. These include

  • Investor financial profile
  • Prevailing tax laws
  • Investment holding periods,
  • Tax and return characteristics of the underlying securities

There are some general principles however, for the types of investments that are best-suited to each type of account.

Taxable Accounts

Tax-friendly stocks should be held in taxable accounts. This is because of their lower capital gains and dividend tax rates and the ability to also defer gains.

Your riskier and more volatile investments also belong in taxable accounts. This is both because of the ability to defer taxes and the ability to capture tax losses on poorly performing investments sold at a recognized loss.

You should hold index funds and ETFs in taxable accounts. The same is true for tax free or tax deferred bonds.

Tax-Deferred Accounts

The following should be in tax-deferred accounts

  • Taxable bonds
  • REITs
  • Related mutual funds

Any mutual funds generating high yearly capital gains distributions should also be placed in tax-deferred accounts.

Asset Location Summary

Asset location is a tax minimizing strategy that determines the proper account to place investments so as to get the most favorable overall tax treatment. You shouldn't use it as a replacement for asset allocation. However, it does it add to the overall after-tax return.

The best location for a security depends on an individual investor's

  • Financial profile (has she maxed out tax protected accounts?)
  • Prevailing tax laws
  • Investment holding periods
  • Tax and return characteristics of the underlying securities

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