Financial assets can be classified into various classes (for instance, domestic stocks, international stocks, taxable bonds, tax-exempt bonds, etc.). These asset classes generate different types of income (qualified dividends, nonqualified dividends, taxable interest, tax-exempt interest, and short- or long-term capital gains). These different types of investment income receive different tax treatments.
Assuming that you have determined an appropriate asset allocation across your client's entire portfolio, the next decision involves which assets go into which accounts.
Types of Accounts The goal of efficient asset location is to hold investments in the type of account that maximizes after-tax return. Most investors have access to two general types of accounts: taxable and tax-deferred. An ordinary brokerage account or a trust account are examples of taxable accounts. Retirement or annuity accounts are usually tax-deferred accounts. Then there are also Roth IRAs, which distribute earnings income tax-free to both the owner and the inheritors. Employer retirement accounts can be either tax-deferred or tax-free (depending on whether it's a traditional or Roth 401(k) account).
Because tax-deferred accounts pay no tax on investment income until the income is withdrawn (or distributed), they are the best choice for taxable bonds, real estate investment trusts and other alternatives that distribute ordinary income or short-term capital gains. An account holding a large fixed-income position would typically be slower-growing than a majority equity account, so an IRA holding mostly bonds would be expected to have lower performance than an equity account.
Taxation of Investment Returns Stocks distribute dividends and generate capital gains upon sale. The dividends from U.S. companies are usually qualified and enjoy a lower tax rate for most investors, as do long-term capital gains from the sale of stock held at least one year. Dividends from international companies and short-term capital gains from the sale of stock held less than one year are taxed as ordinary income.
Stock mutual funds also distribute dividends, as well as long- and short-term capital gains, in addition to generating capital gains upon sale. Market appreciation absent a sale is normally not taxed until shares of a fund are sold or the proceeds distributed. Any losses can be realized and then used to offset current gains or carried over to offset future gains. For these reasons, a taxable account is most appropriate for stocks and stock mutual funds.
As the returns on stocks are expected to be higher than the returns on bonds, it would be expected that a stock account would have better performance than a bond account over time.
In the case of Roth IRAs, the appropriate assets to hold in the account depend on whether the owner expects to use the funds during his or her lifetime or leave them to heirs. If the owner expects to use the funds, then bonds may be appropriate. If not, then stocks will provide a larger inheritance. In any case, the investment return is not taxable to the owner or to the inheritor.
Controlling Required Minimum Distributions Another significant advantage to an effective asset location strategy involves the effect of RMDs over time. Tax-deferred accounts eventually must be distributed, usually when the owner reaches age 70 1/2 (or the account is inherited by a nonspouse). For many larger IRAs, the RMDs can become significant as the owner ages, generating a large taxable income. In many cases, the funds are not needed for normal expenses, but must be distributed (and taxed) anyway.
Placing growth assets into the taxable account and holding taxable fixed income and alternatives in the tax-deferred account will dampen long-term growth relative to an equity account. In contrast, the taxable account holding stocks would be expected to have a higher account balance over time while generating less taxable, current income than if bonds were included in it. This strategy shifts growth to the taxable account, generating a lower account balance over time and thus a smaller RMD.
Keep in mind that this strategy is aspirational in nature; it rarely happens that the accounts are each exactly the right size to hold no equities in IRAs. Also, it usually happens that you will need to hold some cash and fixed income in taxable accounts for any liquidity needs, keeping enough there to fund expected withdrawals or emergencies.
Their Heirs Will Thank You When your client's children inherit a tax-deferred account, they must pay income taxes at their marginal bracket on every dollar distributed. Under current law, they can stretch out these distributions over their lifetime, but they are still taxable when taken. Roth IRAs must also be distributed when inherited by a nonspouse, but those distributions to heirs are not taxable.
Contrast that with inheriting a taxable account, where all the positions receive a step-up in cost basis to fair market value at the owner's death. When the heirs sell these securities, they only realize gains since death, and those are taxed at their long-term capital gains rate.
When adopting an asset location strategy, warn your clients that the performance of these different accounts will vary greatly over time. They must remember to mentally combine the accounts together and consider the portfolio’s performance as a whole.
If a solid asset location strategy is executed properly, your clients will achieve lower currently taxable investment income and their heirs will receive the benefit of a step-up in tax basis on a larger percentage of the portfolio. As an advisor, you will often find that the ability to rebalance on a household level rather than on the account level is generally more tax-efficient.
Helen Modly, CFP, CPWA, is a wealth advisor with Buckingham Strategic Wealth, a fee-only registered investment advisor. The opinions in this article are the author’s own and may not reflect the opinions of Buckingham Strategic Wealth or Morningstar.com. The author may be reached at email@example.com.