Courtesy CFM Tax and Investment Advisors.
By Bill Canty
Asset location pertains to the types of investment assets that are best held in various types of accounts. Asset location is a tax minimization strategy that matches various types of investments with the type of account best suited for that type of investment holding.
Asset location is about strategically holding investments in accounts where you are likely to achieve the highest after-tax returns. This includes taxable investment accounts, tax-deferred accounts such as a traditional IRA or 401(k), or tax-free accounts which are usually Roth accounts.
Due to the nature of dividends, interest, or capital gains connected with certain types of investments, it might be most tax-efficient to hold them in one type of account versus another. This is the essence of asset location.
While it is not always possible to align your entire portfolio in a perfect fashion in terms of asset location for each holding, it does make sense to pay attention to this when deciding which investment holdings fit best into your various accounts.
The following types of holdings can be well-suited for a taxable account:
• Municipal bonds or mutual funds holding muni bonds. The interest on these bonds is exempt from federal income taxes, and in some cases from state taxes if they are issued by an entity in the state in which you reside.
• Individual stocks that you plan to hold for a year or more. After this time period, any capital gains from the sale of the shares will be taxed at preferential long-term capital gains rates.
• Equity index ETFs. Due to the passive management of these types of equity funds, they tend to throw off fewer capital gain distributions than actively managed equity funds or ETFs.
• Tax-managed ETFs, mutual funds, and separately managed accounts. These are mutual funds, ETFs, and SMAs that are managed to specifically limit capital gains and other taxable distributions.
Certain types of investments may be best suited for tax-deferred retirement accounts such as traditional IRA and 401(k) accounts or tax-free Roth accounts. Some examples include:
• Taxable bonds, both individual bonds as well as mutual funds and ETFs that invest in them. Interest paid on bonds is generally taxed at ordinary income tax rates for federal and state tax purposes. Income on Treasury bonds and other debt securities is generally fully taxable at the federal level but exempt from state income taxes.
• REITs (Real Estate Investment Trusts) including mutual funds and ETFs that invest in them. Generally, up to 80 percent of the income generated by a REIT can be taxable as ordinary income to investors with the other 20 percent qualifying as pass-through income in most cases under the Tax Cut and Jobs Act. This exemption is scheduled to expire in 2025.
• Actively managed stock ETFs or mutual funds. Many of these funds generate a high level of short-term capital gains income due to the frequent turnover of holdings in their portfolio. Short-term capital gains do not receive preferential tax treatment and are taxed at ordinary income tax rates.
Asset location can be an important consideration in investing as we all want to invest in the most tax-efficient way possible.
In our opinion, however, asset allocation should govern your investing strategy. This includes the types of investment vehicles, the asset classes included in your portfolio, and the percentage amounts allocated to each of the various asset classes.
Sometimes your situation doesn’t allow you to perfectly align the asset location of every holding within your portfolio. This might be a function of the relative size of the balances in your various types of accounts or other factors.
Where appropriate and feasible, we feel that using asset location principles to determine which holdings are located in various types of accounts makes sense for most investors. However, we would caution investors to use good common sense in implementing an asset location strategy.
For example, incurring unnecessary taxable income to realign your portfolio generally defeats the whole purpose of asset location which is tax savings.
There are a number of ways to realign your portfolio to be more in line with an asset location strategy that best fits your situation. These include:
• Make adjustments in tax-deferred and tax-free retirement accounts whenever possible.
• Use new money to add to positions to help implement an asset location strategy when possible.
When rebalancing your portfolio on a periodic basis, keep your goal of improving your portfolio’s asset location strategy in mind. If you can utilize any tax losses you harvest from taxable accounts in the process, so much the better.
When considering an asset location strategy for your portfolio, it’s important to keep both current and future tax implications in mind. For example, will you be in a higher or lower tax bracket in retirement?
Asset location should be implemented as part of your overall financial plan and your investing strategy. If done correctly, asset location can be a key tool in your tax planning efforts.
If you are looking for a fee-only fiduciary financial advisor who will always put your interests first, please give us a call to discuss asset location or any other financial issues. We are here to help.