Asset location is a tax-minimization strategy that takes advantage of different types of accounts getting different tax treatments. Using this strategy, an investor determines which securities may be appropriate for which types of accounts to maximize after-tax returns1.
Asset allocation sounds similar to asset location but it means something very different. Asset allocation involves designing the appropriate mix of stocks, bonds and cash in a portfolio to help reduce portfolio volatility2,3.
Asset allocation decisions normally precede asset location decisions. Once you determine the proper asset mix for your portfolio to potentially manage volatility, you then proceed to position those investments in the appropriate accounts to help minimize taxes.
Types of Accounts
For the purpose of this article, we will consider three basic types of investment account types according to their income tax characteristics:
- Non-retirement accounts, such as individual, joint or trust-owned accounts.
- Tax-deferred accounts, such as an IRA, 401(k) or other retirement accounts.
- Tax-advantaged accounts (some refer to these accounts as “tax-exempt”1), such as Roth IRA, Roth 401(k) or health savings accounts.
- Non-retirement brokerage accounts:
Investments held in non-retirement accounts may be taxed on capital gains, interest income and dividends. For example, if you sell a stock in these types of accounts at a price higher than your purchase price, you will have a capital gain for which you may owe a tax. Short-term capital gains (generally assets held a year or less) and interest income may be taxed as ordinary income at the taxpayer’s marginal tax rate. Long-term capital gains (generally assets held longer than a year) and qualified dividends can receive preferential tax treatment and may be capped at 20% for the highest taxpayers with a few exceptions.4
- Tax-deferred accounts:
Tax-deferred accounts are those where income taxation on gains, dividends and interest and any contributed principal not previously subject to income tax are delayed until funds are actually distributed from the account. Income tax may then be applied to the amount distributed. Selling investments in a tax-deferred account such as an IRA or 401(k), will not generate taxation in the year of the sale unless the sales proceeds are distributed out of the tax-deferred account. Also, interest income and dividends are not taxed in IRAs or 401(k)s until withdrawn at a later time, such as in retirement. Distributions from IRAs and 401(k)s are generally taxable as ordinary income at the taxpayer’s marginal tax rate.5
- Tax-Advantaged accounts:
In a “tax-advantaged” account as the term is being used in this article, investments may be made with after-tax income (Roth IRAs, for example) or pre-tax income (health savings accounts, for example). Whatever is earned in the account may grow tax free and qualified distributions may not be income taxable under defined circumstances.6 The rules which describe qualified distributions and the defined circumstances may be somewhat complex and are beyond the scope of this article.
Asset Location for Tax-Deferred Accounts
It may be preferable to hold taxable bonds (including taxable bond funds) and actively managed mutual funds in tax-deferred accounts. With the exception of municipal bonds or municipal bond funds which may be exempt from federal taxes, most bond funds are not very tax-efficient because they generate a large portion of their returns from regular interest payments.
These interest payments are generally taxed as ordinary income tax. For many people, these rates are generally higher than the tax rates on long-term capital gains and dividends. As a result, it may be advantageous to hold bonds and bond funds in tax-deferred accounts to allow them to effectively earn the pre-tax return on the assets.7
Generally speaking, mutual funds are required to distribute their capital gains each year.9 Actively managed funds tend to be less tax-efficient than their index counterparts because they tend to have a higher turnover of the securities making up the fund and a greater chance of realizing capital gains from the trading. Just as with individuals, when a mutual fund manager sells a security it owns for more than it paid, a capital gain may be generated.8
When fund shareowners sell their mutual fund shares, fund managers may be required to sell some of the fund’s underlying holdings to raise cash to fund the sales, which in turn, may lead to realizing more capital gains. Capital gains may even be distributed to shareholders who may have an unrealized loss on the overall mutual fund investment because the current share price is lower than their purchase price, but they haven’t yet sold their shares. Given these considerations, it may be more advantageous to hold actively managed funds in tax-deferred accounts rather than in taxable brokerage accounts.
Asset Location for Non-Retirement Accounts
It may be preferable to hold more tax-efficient investments in non-retirement (taxable) accounts. Examples of these may include equity index funds, particularly exchange-traded funds (ETFs) and municipal-bond funds.10
Equity index funds and exchange traded funds are generally more tax-efficient than actively managed mutual funds because they tend to have lower turnover. The structure of ETFs builds on this tax advantage by trading in the secondary market. When a mutual fund investor asks for their money back, the mutual fund may need to sell securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, it is simply sold to another investor like a stock.11
Aside from the equity holdings described above, municipal bonds and municipal bond funds are good candidates for non-retirement accounts as they may be exempt from federal income tax (and maybe from state income tax as well if the owner resides in the state of the issuer).12 As a result of their potentially favorable tax status, municipal bonds may offer lower yields than their taxable counterparts. However, investors in the highest tax brackets may still secure better after-tax yields than with higher yielding taxable bonds with similar risk.
Asset Location for Tax-Advantaged Accounts
Earnings in tax-advantaged accounts may grow tax-free and distributions may be tax-free, as long as certain criteria have been met. Therefore, it may make sense to try to maximize gains .by holding assets that have the potential to appreciate significantly and/or assets that are designed to generate higher income in these types of accounts. Examples might include growth stocks or high yield bonds. Actively managed funds with high turnover may also be appropriate in these accounts since there may be no tax consequences for capital gains.13 Along with higher potential return from these types of assets, short-term volatility may be expected.
What about REITs?
REIT is an acronym that stands for Real Estate Investment Trust. A REIT is a company that may own, operate or finance income producing real estate making it possible for its shareholders to share in the income without actually having to buy or manage the property themselves.16
Their distributions generally consist of three components: (1) dividends; (2) capital gains; and (3) non-dividend distributions. Some of these distributions may be taxed as ordinary income, some as capital gains income and some may be a return of capital.14 The actual percentage breakout of REIT distributions may vary from company to company. Some REITs may distribute a larger percentage of ordinary income and less capital gains than other REITs.
What about the distribution portion normally classified as ordinary income? REIT investors were big winners from the 2017 Tax Cut and Jobs Act (TCJA). One of the provisions of TCJA allowed eligible small business owners to deduct up to 20% of qualifying business income (QBI) on their tax returns. Based upon Section 199A of the law, normal REIT distributions may also qualify as QBI. This means that REIT owners may receive a deduction equal to 20% of their REIT distributions. Qualified REIT dividends are defined as any dividends that are not capital gains or non-REIT dividend income.15 In other words, most “normal” REIT income (the ordinary income portion) may be eligible for Section 199A deduction.
As a result of the Section 199A of the new law, it may now more attractive to hold REITs in taxable accounts than in prior years (as the QBI deduction is lost if the REITs are held in a tax-deferred account). However, with several new tax laws being introduced the TCJA is expected to expire in 2025.
Conclusion
The asset location decisions may be complicated.
Tax-deferred accounts, like 401(k)s and IRAs may be a good place to park less tax-efficient investments, like taxable-bonds or bond funds and actively managed funds. Non-retirement accounts may be reserved for more-tax-efficient strategies, including low-turnover equity index funds or municipal bond funds. Tax-advantaged accounts, such as Roth IRAs and health savings accounts, may be a good place to hold assets with high growth potential, generous income payouts or actively managed mutual funds. Although REITs may be better suited for tax-advantaged accounts (IRAs or Roth IRAs), recent legislation has improved their appeal in non-retirement accounts.
The above is a very brief overview of how asset location may be used to minimize taxes. The subject is much more complex and nuanced than described here. For example, we have not discussed annuities and cash value life insurance policies which could be part of the asset location decision as well. Moreover, tax-efficiency is only one factor in determining asset location. Other factors may be just as important, such as the investor’s time horizon, risk tolerance and the available investment options. The available capital in each type of account may also limit overall efficient asset location.
At the Family Wealth Decisions Group, we consider every client’s situation individually and holistically before collaboratively designing investment recommendations. If you would like to discuss your asset location decisions, please feel free to contact us. Remember, we are here to help.
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- https://www.fidelity.com/viewpoints/investing-ideas/asset-location-lower-taxes
- https://www.sec.gov/about/reports-publications/investor-publications/investor-pubs-asset-allocation
- https://www.forbes.com/advisor/investing/what-is-asset-allocation/
- https://www.irs.gov/taxtopics/tc409
- https://www.investopedia.com/terms/t/taxdeferred.asp
- https://www.synchronybank.com/blog/what-is-a-tax-advantaged-account/
- https://personal.utdallas.edu/~hxz054000/JOFI_2.pdf
- https://www.investopedia.com/ask/answers/091715/how-often-do-mutual-funds-pay-capital-gains.asp
- https://www.investopedia.com/ask/answers/07/mfdistribution.asp
- https://investor.vanguard.com/investor-resources-education/taxes/tax-saving-investments
- https://www.etf.com/etf-education-center/etf-basics/why-are-etfs-so-tax-efficient. There are situations in which ETFs may be redeemed. This usually occurs when the market price of the ETF does not correlate closely with the underlying basket of stocks. In these circumstances “authorized participants” (usually, large banks) redeem ETF shares in exchange for the underlying basket of stocks. These redemptions are considered “in kind” exchanges and not capital gains. As such, they are not considered taxable events.
- https://www.investopedia.com/ask/answers/060215/how-are-municipal-bonds-taxed.asp
- https://www.nerdwallet.com/article/investing/these-are-the-best-roth-ira-investments
- https://www.reit.com/investing/investing-reits/taxes-reit-investment
- https://www.irs.gov/newsroom/qualified-business-income-deduction
- https://www.reit.com/what-reit