- An investing strategy called asset location has the potential to help lower your overall tax bill.
- Know the differences between taxable, tax-deferred, and tax-exempt accounts.
- By putting high tax investments in tax-deferred or tax-exempt accounts rather than taxable accounts, you can potentially improve the overall tax efficiency of your investments.
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. Sorting your investments into different accounts—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.
Know the 3 main types of investing accounts
Many investors have several different types of accounts that can be aligned with specific investing goals. Some are subject to taxes every year, while others have tax advantages. Here are the 3 main investment account categories:
- Taxable accounts such as traditional brokerage accounts hold securities (stocks, bonds, mutual funds, ETFs) that are taxed when you earn dividends or interest, or you realize capital gains by selling investments that went up in value.
- Tax-deferred accounts like traditional 401(k)s, 403(b)s and IRAs allow payment of taxes to be delayed until money is withdrawn, when it is taxed as ordinary income.
- Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s require income 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). Fully tax-exempt accounts such as health savings accounts (HSAs), allow you to make pretax or deductible contributions, earnings, or withdrawals, if used for qualified health expenses.1
Remember, contribution limits2 prevent investors from simply saving everything in tax-advantaged accounts.
Asset location in action
Let's look at a hypothetical example. Say Adrian is thinking about diversifying his portfolio by 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 should he hold the investment? The answer matters, especially since taxable bond interest is taxed as income at relatively high income tax rates.
If Adrian chooses a tax-deferred account such as a traditional IRA, the proceeds of the sale after taxes could be nearly $72,000 greater than in a taxable account. If Adrian cannot make the investment in a traditional IRA, he might still benefit from tax deferral by making his investment in a tax-deferred variable annuity, which is not subject to contribution limits. In this case, the 0.25% annual fee of the annuity does offset some of the benefits of tax deferral, but Adrian still ends up nearly $47,000 better off.
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, as interest on taxable bonds can be.
Tip: If you've already hit the contribution limits of your tax-advantaged 401(k) or IRA, you may want to consider a deferred annuity as part of your tax-deferred retirement savings strategy. Read Viewpoints on Fidelity.com: Create future retirement income
Can you benefit from an active asset location strategy?
There are 4 main criteria that tend to indicate whether an asset location strategy may be a smart move for you. The more of these criteria that apply to your situation, the greater the potential advantage in seeking enhanced after-tax returns.
- You currently pay a high marginal income tax rate: The higher the marginal income tax rate you currently pay, the bigger the potential benefits of asset location. Remember, as you earn more money, you may move into a higher marginal tax bracket. Consequently, the benefit of your additional income can be significantly reduced if you are being taxed at a higher marginal tax rate.
- You expect to pay a lower marginal income tax rate in the future: If you expect your marginal income tax rate to be lower in the future than it is now, active asset location may allow you not only to defer your taxes but to reduce them as well. Note that it is very common for investors to see their marginal income tax rate fall following retirement, and if you have assets with a time horizon into retirement, this may well be the case for you.
- You have significant assets in tax-inefficient investments held in taxable accounts: The more tax-inefficient investments, such as taxable bonds and taxable bond funds, you're currently holding in taxable accounts (see chart, below), the greater the potential to take advantage of asset location.
- You expect to be invested for more than 10 years: Asset location strategies generally take time to work. As a general rule, they require at least 10 years to be effective to a significant degree. And the longer you can keep your assets invested, the greater the potential benefits from tax deferral.
Rate your investments on a tax-advantaged scale
If you are in a position to benefit from an asset location strategy, you have to choose which assets to assign to your tax-advantaged accounts and which to leave in your taxable accounts.
In general, the following are higher on the tax-advantaged scale:
- Individual stocks are, as a general rule, relatively tax-advantaged if bought and held for at least a year.3
- Equity index mutual funds and ETFs are generally quite tax-advantaged.
- Tax-managed equity funds (that is, equity funds that name tax management as an explicit goal) tend to be highly tax-advantaged.
In general, these are lower on the tax-advantaged scale:
- Bonds and bond funds (with the exception of tax-free municipal bonds and funds, and US Savings Bonds) are generally highly tax-disadvantaged, because they generate interest payments that are taxed at relatively high ordinary income rates. Potentially higher returning types of bond investments, such as US high yield and emerging markets bond funds, are the most tax-disadvantaged.
- Actively managed stock funds with high turnover rates are less tax-advantaged because they tend to have high rates of capital gain distributions. They sometimes even distribute short-term capital gains, which are taxed at the higher ordinary income tax rates.
Locate investments where they may help enhance after-tax returns
So, which investments do you put where to help enhance after-tax returns? Each person will have to find the right approach for their particular situation. But generally, depending on your overall asset allocation, you may want to consider putting the most tax-advantaged investments in taxable accounts and the least in tax-deferred accounts like a traditional IRA, 401(k), or a deferred annuity, or a tax-exempt account such as a Roth IRA (see chart 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.
"Investors should start out with a solid plan for their asset allocation, but within that framework, having a good strategy for where you keep your investments can be important," says Kenigsberg. "By putting certain less tax-advantaged investments in a tax-deferred or tax-exempt account, you can potentially save a significant amount of money on taxes, which may help you improve your bottom line as an investor."
Remember, the process of developing an asset location strategy is complicated, so consider working with a financial professional who can assist you with asset location as well as working with you to develop a solid financial plan to help you reach your financial goals.