Why asset location matters

Choosing the right account may help you keep more of your investing gains.

  • Taxes
  • 401(k)
  • 403(b)
  • IRA
  • Managed Accounts
  • Retirement Accounts
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In real estate, it's location, location, location. In investing, the same bit of wisdom also has a place. Where you put your investments—meaning the type of account you choose—can make a major difference in how much you can earn, after tax, over time.

Should you use your brokerage account for the REIT fund you are investing in, or would it be better in your tax-deferred annuity? What about the growth stocks you have been eyeing or the municipal bonds you are laddering toward retirement income—should those go into a Roth or into your taxable account?

"You can't control market returns, and you can't control tax law, but you can control how you use accounts that offer tax advantages—and good decisions about their use can add significantly to your bottom line," says Matthew Kenigsberg, a senior vice president in Strategic Advisers, Inc., a Fidelity Investments company.

This type of tax-savvy strategy is often referred to as active asset location.

How an active asset location strategy works

Let's look at a hypothetical example (illustrated below). Say Adrian is thinking about investing $250,000 in a taxable bond fund for 20 years. For this example, we will assume Adrian pays a 36.8% marginal income tax rate and earns a 6% rate of return each year—before taxes. (Actual rates of return may vary.)

But in which account will he hold the investment? The answer matters. If he chooses a tax-deferred IRA, his liquidation value—the proceeds of the sale after taxes and transaction fees—could be nearly $75,000 greater than in a taxable account. If he chooses a tax-deferred variable annuity, his liquidation value might be nearly $50,000 more than in a taxable account.

As you can see, tax deferral has the potential to make a big difference for investors—especially when matched with investments that may be subject to significant taxation. As illustrated in the hypothetical example above, qualified accounts such as IRAs, 401(k)s, 403(b)s, or other workplace savings plans may provide the greatest benefits in an asset location strategy. However, investors who have already made the most of these tax-preferred investment vehicles, or who may not be eligible for them, may want to consider deferred annuities. Although they charge additional fees and may be subject to different withdrawal rules, such annuities can provide an additional option for tax-deferred saving—and one that is not subject to limits on the amount invested, as is the case with IRAs, 401(k)s, and other qualified retirement accounts.

Can you benefit from an active asset location strategy?

Many investors have several different types of accounts. Some are subject to taxes every year, while others have tax advantages: Tax-deferred accounts like traditional IRAs allow payment of taxes to be delayed until money is withdrawn from them, while tax-exempt accounts like Roth IRAs require taxes to be paid on all contributions up front, but then allow the investor to avoid further taxation (as long as the rules are followed). Typically, restrictions on contributions or withdrawals prevent investors from simply saving everything in tax-advantaged accounts. So how do you decide what to put where?

There are four main criteria that tend to indicate whether an active asset location strategy may be a smart move for you. The more these criteria apply to your situation, the greater the potential advantage in after-tax returns.

  • You pay a high marginal income tax rate: The higher the marginal income tax rate you pay, the bigger the potential benefits of active asset location. If you are in one of the highest three federal tax brackets, or if you live in a city or state with high income taxes, or both, a strategy to help make the location of your investments more tax efficient could be an easy way to boost your after-tax returns without assuming additional risk.
  • You expect lower income taxes in retirement: If you plan to move to a state with much lower income taxes, or expect to be in a lower tax bracket due to reduced taxable income after you stop working, or both, an investment strategy designed to take advantage of additional tax deferral now can have a big impact later. This is because in addition to delaying taxation—which has significant benefits of its own—you will pay taxes at a lower rate in the future.
  • You have a lot of tax-inefficient investments in taxable accounts: The more tax-inefficient assets you're currently holding in taxable accounts (see below), the greater the potential to take advantage of active asset location.
  • You expect to be invested for more than 10 years: Active asset location strategies generally take time to work (as a general rule, they require at least 10 years to be effective). The longer you can keep your assets invested, the greater the potential benefits from tax deferral. So if you are saving for retirement and expect to work at least another 10 years, or won't need to use the money in your tax-advantaged accounts any sooner than that, an active tax location strategy could have a big impact. Note, however, that under some circumstances—such as a sharp drop in income or a move from a domicile with high state or local taxes to one with none—active asset location can have a significant impact in less than 10 years.

First, rate your investments on a tax-efficiency scale

If you are in position to take advantage of an active asset location strategy, you have to choose which assets to keep in your tax-advantaged accounts and which to leave in your taxable accounts.

All else being equal, the more tax inefficient an investment is, the more tax you pay on it every year if it's held in a taxable account. Below, we present ratings on several investment types. Of course, there is no way to know exactly what tax rates will apply to your investments in the future, but in general:

  • Bonds, with the exception of tax-free municipal bonds and U.S. Saving Bonds, are generally highly tax inefficient, because they generate interest payments that are taxed at ordinary income rates. Potentially higher returning, more volatile types of fixed-income investments are the most tax inefficient.
  • REITs are also rated low on the tax-efficiency scale. That's because they are required by law to pay out at least 90% of their taxable income, and, unlike other equities, this income is generally taxed at higher ordinary income rates.
  • Individual stocks are, as a general rule, relatively tax efficient. This is because qualified dividends and capital gains on the sale of stocks held a year or more are currently taxed at a top federal rate of 23.8% (this includes the top long-term capital gain rate of 20% plus the 3.8% Medicare surtax on net investment income). Investors with lower taxable income would pay rates of 18.8%, 15%, or even, in some cases, 0%. Equity-based exchange-traded funds (ETFs) are essentially taxed like stocks in most cases. However, note that the phaseout of itemized deductions could, in an indirect way, drive the marginal tax rate you pay on stocks somewhat higher if you're a high-income earner.
  • Stocks mutual funds are more complex. While stock index funds are generally quite tax efficient, many actively managed stock funds are tax inefficient because of high turnover rates. They can distribute short-term capital gains, which are taxed at the higher ordinary income tax rates. Although it is difficult to make generalizations about which actively managed funds are more or less tax efficient, as you can see in the tax efficiency table, large-cap funds have historically tended to be more tax efficient on average than otherwise similar small-cap ones (recently, foreign value funds have been an exception to this rule).

Then, locate your investments where they may help enhance after-tax returns

So, which investments do you put where to help maximize after-tax returns? Each person will have to find the right approach for his or her particular situation. But generally you may want to consider putting the most tax-efficient investments in taxable accounts and the least in tax-deferred accounts like a traditional IRA, 401(k), or deferred annuity, or a tax exempt account such as a Roth IRA (see table below).

To get going, consider first checking to see whether you've already taken full advantage of a 401(k) plan, Keogh, IRA, or other qualified retirement account that may be available to you. Generally, these accounts are the best place to start a program of active asset location, because they may cost less than other options, but each comes with contribution and withdrawal restrictions.

Once you have maxed out those options, you might think about assigning any clearly tax-inefficient assets remaining in your taxable accounts to a low-cost tax-deferred variable annuity, so they too may benefit from tax-deferred growth potential. When choosing to invest in an annuity, you need to consider the costs, contribution restrictions, and the rules concerning how and when you can access your money.

"Deferring taxes may improve your bottom line as an investor," says Kenigsberg. "Investors should start out with a solid plan for their asset allocation, but within that framework we think having a good strategy for where you keep your investments can be important."

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund or variable annuity and its investment options. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
1. The marginal income tax rates listed here are federal rates, and include both the marginal income tax bracket (33%) and the Medicare surtax on net investment income of 3.8%. Neither state nor local taxes are included.
More legal information from chart:
In the taxable account, it is assumed that taxes incurred on the income are paid annually from the income itself, with the remainder reinvested. In the tax-deferred account, it is assumed that all income is reinvested. For the VA, it is assumed that all income—less the 0.25% annual annuity charge, billed quarterly—is reinvested. It is assumed that the investor liquidates the VA and the tax-deferred account at the end of the time period, and pays taxes on the gains out of the proceeds. If the assets in these accounts were liquidated entirely in one year, the proceeds might increase the tax bracket to the marginal federal income tax rate of 43.4% (39.6% ordinary income tax plus 3.8% Medicare surtax), which would minimize and potentially eliminate any savings. To avoid this, the VA and tax-deferred account would need to be liquidated over the course of several years or annuitized, which would lengthen the deferral period.

State and local taxes, inflation, and fund and transaction fees were not taken into account in this example; if they had been, performance for the taxable account, the variable annuity, and the tax-deferred account would be lower. This example also does not take into account capital loss carryforwards or other tax strategies that could be used to reduce taxes that could be incurred in a taxable account; to the extent these strategies apply to your situation, the comparative advantage of the variable annuity and tax-deferred account would be diminished. Lower tax rates on interest income would make the taxable investment more favorable. Changes in tax rates and tax treatment of investment earnings may impact the comparative results. Consider your current and anticipated investment horizon and income tax bracket when making an investment decision, as the illustration may not reflect these factors.

Ordinary income tax rates will apply to taxable amounts withdrawn from a tax-deferred investment.

The year-by-year account value for the taxable account shown above is: $259,480 for year 1, $269,319 for year 2, $279,532 for year 3, $290,132 for year 4, $301,134 for year 5, $312,553 for year 6, $324,405 for year 7, $336,706 for year 8, $349,474 for year 9, $362,726 for year 10, $376,481 for year 11, $390,757 for year 12, $405,574 for year 13, $420,954 for year 14, $436,916 for year 15, $453,484 for year 16, $470,680 for year 17, $488,528 for year 18, $507,053 for year 19, and $526,281 in year 20. The year-by-year value after federal income taxes have been deducted for the VA with 6% return less the 0.25% annual annuity charge shown above is: $259,061 for year 1, $268,642 for year 2, $278,773 for year 3, $289,484 for year 4, $300,810 for year 5, $312,785 for year 6, $325,447 for year 7, $338,835 for year 8, $352,991 for year 9, $367,959 for year 10, $383,785 for year 11, $400,519 for year 12, $418,213 for year 13, $436,921 for year 14, $456,702 for year 15, $477,618 for year 16, $499,733 for year 17, $523,117 for year 18, $547,841 for year 19, and $573,984 in year 20. The year-by-year value for the VA at a 0% annual return less the 0.25% annual annuity charge is: $249,375 for year 1, $248,752 for year 2, $248,130 for year 3, $247,509 for year 4, $246,891 for year 5, $246,273 for year 6, $245,658 for year 7, $245,044 for year 8, $244,431 for year 9, $243,820 for year 10, $243,210 for year 11, $242,602 for year 12, $241,996 for year 13, $241,391 for year 14, $240,787 for year 15, $240,185 for year 16, $239,585 for year 17, $238,986 for year 18, $238,388 for year 19, $237,792 for year 20.

Withdrawals of taxable amounts from tax-deferred IRAs and annuities are subject to ordinary income tax rates, and, if taken before age 59½, may be subject to a 10% IRS penalty.

VAs are generally not suitable for investors with a time horizons of less than 10 years, as in most cases there is little to no advantage over a taxable account for the first 10 years of the investment.
Tax cost ratio
The Morningstar tax cost ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions. Mutual funds regularly distribute stock dividends, bond dividends, and capital gains to their shareholders. Investors must then pay taxes on those distributions during the year they were received.

Like an expense ratio, the tax cost ratio is a measure of how one factor can negatively impact performance. Also like an expense ratio, it is usually concentrated in the range of 0%–5%, where 0% indicates that the fund had no taxable distributions and 5% indicates that the fund was less tax efficient.

For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pretax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)

The tax cost ratio provides additional information that is not available from after-tax returns alone.

• Per the SEC's guidance, after-tax returns reflect both tax effects and sales loads. The tax cost ratio isolates the effects of taxes alone.
• Different categories of funds and different time periods will have varying levels of pre- and after-tax returns. The tax cost ratio is independent of the level of the return and it is always expressed on an annualized basis. Therefore, it can be used to compare different funds, categories, managers, and time periods. For example, you can compare the three-year and 10-year tax cost ratios for the same fund to see if the manager has become better at managing tax issues in more recent years.

Morningstar calculates the tax cost ratio in-house on a monthly basis, using load-adjusted and tax-adjusted returns for different time periods. Morningstar uses the tax-adjusted return that is called "pre-liquidation after-tax return," which is also known as "return after taxes on distributions." Morningstar calculates this statistic for open-end mutual funds, exchange-traded funds, and variable annuity underlying funds based in the United States.
Assumptions
Because the tax cost ratio is based on after-tax returns , it is based on the same assumptions as those returns and it is an estimate of what the hypothetical investor would experience. For example, after-tax returns assume that investors pay the maximum federal tax rate on capital gains and ordinary income.

Calculation
The tax cost ratio for time i, Ti, is
Ti = 1 – (1 + ATRi)/(1 + Li)
where
ATRi = annualized pre-liquidation after-tax return for the time period i. (This is also load-adjusted.)
Li = annualized load-adjusted pretax return for the time period i
The tax cost ratio is a positive expression of a negative rate of return that is due to taxes. By rewriting the equation, it is apparent that the after-tax return is the same as compounding the load-adjusted return and the tax cost ratio negative return.
(1 + ATRi) = (1 + Li)(1 – Ti)
(1 + after-tax return) = (1 + load-adjusted return) (1 + negative rate of return for taxes, i.e. tax cost ratio)

The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide estate planning, legal, or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Withdrawals of taxable amounts from an annuity are subject to ordinary income tax, and, if taken before age 59½, may be subject to a 10% IRS penalty.
Investing in a variable annuity involves risk of loss; investment returns and contract value are not guaranteed and will fluctuate.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed-income investments.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund.
Investing in small-cap stocks may have greater risk because they are subject to abrupt or erratic price fluctuations.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund.
Investing in small-cap stocks may have greater risk because they are subject to abrupt or erratic price fluctuations.
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