- While tax treatment is important, investors should start with a strategy for the mix of investments they will own.
- Tax deferral has the potential to make a big difference for investors.
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. That's because different investments are subject to different tax rules, and different types of accounts have different tax treatment. Attempting to sort investments into accounts to lower your overall tax bill—a strategy often called active asset location—has the potential to help lower your overall tax bill.
Should you use your brokerage account for the real estate investment trust (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 account 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, Vice President, Investment & Tax Solutions at Fidelity Investments. While tax treatment is important, investors should start with a strategy for the mix of investments they will own. That asset allocation strategy should be based on goals, financial situation, risk tolerance, and investment horizon. Once your asset allocation is in place, active asset location may be worth considering, in an attempt to help improve after-tax returns.
How an active asset location strategy works
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have tax advantages: Tax-deferred accounts like traditional IRAs allow payment of taxes to be delayed until money is withdrawn from them, while tax-exempt accounts like Roth IRAs require taxes to be paid on all contributions up front, but then allow the investor to avoid further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, contribution limits prevent investors from simply saving everything in tax-advantaged accounts.
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 35.8% marginal income tax rate and the bond fund is assumed to earn a 6% rate of return each year—before taxes. (Actual rates of return may vary.)
In what account will he hold the investment? The answer matters. If he chooses a tax-deferred account such as a traditional IRA, his liquidation value—the proceeds of the sale after taxes and transaction fees —could be nearly $72,000 greater than in a taxable account. If he chooses a tax-deferred variable annuity, his liquidation value might be nearly $47,000 more than in a taxable account. (See assumptions in chart below.)
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 high tax rates on gains or dividends. As illustrated in the hypothetical example above, qualified accounts such as IRAs, 401(k)s, 403(b)s or other workplace savings plans, which offer tax deferral or in some cases tax-free gains and may offer low account expenses, may provide the greatest benefits in an asset location strategy. However, investors who have already hit the contribution limits of these tax-advantaged 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 deferred 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?
So how do you decide what to put where?
There are 3 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 seeking enhanced 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 3 federal tax brackets, or if you live in a city or state with high state or local income taxes, or both, a strategy to help make the location of your investments more tax-aware could be an easy way to help boost your after-tax returns without assuming additional risk.
You have a lot of tax-inefficient investments in taxable accounts: The more tax-inefficient assets you're currently holding in taxable accounts (see chart, 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 an impact. Note, however, that under some circumstances—such as a sharp drop in income or a move from a place 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 a position to take advantage of an active asset location strategy, you have to choose which assets to assign to 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 some general characterizations of several investment types. Of course, there is no way to know exactly what tax rates will apply to your investments in the future and the future tax-efficiency of specific investments is also unknowable. But in general:
Bonds, with the exception of tax-free municipal bonds and US Saving Bonds, are generally highly tax-inefficient, because they generate interest payments that are taxed at ordinary income rates. Potentially higher returning types of fixed income investments, such as US High Yield and Emerging Markets Debt, 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 if bought and held for at least a year. This is because capital gains on the sale of stocks held for more than a year 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.
Stock mutual funds are more complex. While stock index funds and index ETFs are generally quite tax-efficient, many actively managed stock funds are tax-inefficient because of high turnover rates. They sometimes 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, large-cap funds have historically tended to be more tax-efficient on average than otherwise similar small-cap ones. Also, be aware that some equity funds are explicitly managed for tax efficiency, and they tend to be highly efficient despite being actively managed.
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 their 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 typically don’t come with account fees, like some 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 still 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."
Next steps to consider
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