Asset location is a tax-minimization strategy that takes advantage of different types of investments getting different tax treatments. Using this strategy, an investor determines which securities may be appropriate for which types of accounts to maximize after-tax returns.
Asset allocation decisions normally precede asset location strategies. Asset allocation is the positioning of equities, bonds, mutual funds, and other holdings in a portfolio across different asset classes to cushion market downturns. Once you determine the proper asset mix for your portfolio, you may then proceed to position those investments in the appropriate accounts to minimize taxes.
Types of Accounts
For purposes of this article, there are three basic types of investment accounts according to taxation.
- A non-retirement account that can be individual, joint or trust-owned
- A tax-deferred account, such as an IRA and 401(k)
- A tax-exempt account, such as Roth IRA, Roth 401(k) or health savings account.
Regular brokerage Accounts
Investments held in non-retirement accounts are taxed on capital gains and on interest income and dividends. For example, if you sell a stock at a price higher than the price you purchased it, you will have a capital gain for which you will owe a tax. Short-term capital gains (assets held a year or less) and interest income are taxed as ordinary income at the taxpayer’s marginal tax rate. Long-term capital gains (assets held longer than a year) and qualified dividends are given preferential tax treatment and capped at 20% for the highest taxpayers. For single filers with an adjusted gross income (AGI) of more than $200,000 and most couples filing jointly with an AGI above $250,000, there is an additional surtax.
Tax deferred accounts
Taxation is significantly different in tax-deferred accounts than in non-retirement accounts. Selling investments in a tax-deferred account, such as an IRA or 401(k), will not generate capital gains taxes. In fact, selling funds in a tax-deferred account generates no immediate taxes. Also, interest income and dividends are not taxed in IRAs or 401(k)s until withdrawn at a later time, such as retirement. Distributions from IRAs and 401(k)s are generally taxable as ordinary income at the marginal tax rate.
Tax exempt accounts
In a tax-exempt account, investments may be made with after-tax income (Roth IRAs) or pre-tax income (health savings accounts). Whatever is earned in the account grows tax free and distributions may not be taxable under designated circumstances.
Asset Location for Tax-deferred Accounts
It may be preferable to hold taxable bonds (and taxable bond funds) and actively managed mutual funds in tax-deferred accounts.
With the exception of municipal bonds or municipal bond funds, which are 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 payments are taxed at ordinary rates, which for many people are higher than the tax rates on long-term capital gains and dividends, and investors cannot defer them. As a result, it may be advantageous to hold bonds and bond funds in tax-deferred accounts.1
Generally speaking, mutual funds are required to distribute their capital gains each year.2 Actively managed funds tend to be less tax-efficient than their index counterparts because they tend to have higher turnover. This leads to more sales in the portfolio and a greater chance of realizing capital gains. The structure of mutual funds may add to greater turnover. Outflows from mutual funds may require managers to sell some of their holdings to raise cash, which in turn, may lead to more capital gains. Capital gains may occur even for shareholders who may have an unrealized loss on the overall mutual fund investment. Given these considerations, it may be more advantageous to hold actively managed funds in tax-deferred accounts than in taxable brokerage accounts.3
Asset Location for Non-Retirement Accounts
It may be preferable to hold more tax-efficient investments in non-retirement (taxable) accounts. These include (1) equity index funds, particularly exchange-traded funds (ETFs), (2) funds that invest in foreign stocks, and (3) municipal-bond funds.4
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 her 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, he simply sells it to another investor like a stock.5
Index funds that invest in foreign stocks are especially well-suited for taxable accounts because investors can receive a tax credit for foreign withholding taxes on dividends, but only if they are held in a taxable account. If you hold these funds in a tax-sheltered account, the fund still pays the foreign withholding taxes on dividend income, but you normally do not recoup them.6
Aside from the equity holdings described above, municipal bonds and municipal bond funds are good candidates for non-retirement accounts. This is because they may be exempt from federal taxes (and state taxes if the owner resides in the state of the issuer). Because of their favorable tax status, municipal bonds tend to offer lower yields than their taxable counterparts. But for investors in the highest tax brackets, municipal bonds generally offer better after-tax yields than taxable bonds with similar risk.
Asset Location for Tax-Exempt Accounts
Given that earnings in tax-exempt accounts grow tax-free and distributions may be tax-free, it may make sense to try to maximize gains by holding highly appreciative assets and/or assets that generate higher income in these accounts. Examples might be growth stocks or high yield bonds. Actively managed funds with high turnover may also be appropriate in these accounts since there are no tax consequences for capital gains.7 Along with higher potential return from these types of assets, short-term volatility may be expected.
What about REITs?
It is often stated that REITs should be held in tax-advantaged accounts (such as IRAs or Roth IRAs) rather than in brokerage accounts.8 This is because their payouts represent a large portion of returns and much of their payouts are taxed as ordinary income. However, recent changes in legislation improve the appeal for REITs in brokerage accounts.
REITs distributions consist of three parts. Part may be ordinary income, part may be capital gains and part may be a return of capital. Since 1995, roughly 70% of all REIT distributions have been classified as ordinary income. Fifteen percent has been considered capital gains, and 15% has been called return of capital.9 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 receive a deduction 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. The deduction applies to “qualified REIT dividends.” Qualified REIT dividends are defined as any dividends that are not capital gains or non-REIT dividend income. In other words, most “normal” REIT income (the “ordinary” income portion) may be eligible for Section 199A deduction.10
Since the QBI deduction allows 20% of the REIT’s income to be deducted against itself, the investor only pays taxes at 80% of the “normal” ordinary income rate. Thus, the 10% tax bracket on REITs is really only taxed at 8%, and an investor in the top 37% tax bracket on their REIT income pays at only a 29.6% rate.11
As a result of the Section 199A of the new law, it is 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).
Conclusion
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 exempt 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.
This is a very brief overview of how asset location may be used to minimize taxes. The subject is more complex and nuanced than described here. 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 available investment options. The available capital in each type of account may also limit overall efficient asset location. All things considered, you may need to be flexible when making asset location decisions. At Family Wealth Decisions Group, we consider every client’s situation holistically before making investment recommendations. If you would like to know more about this topic, please feel free to contact us. Remember, we are here to help.
Doug Lemons, CFP®
Asset allocation won’t guarantee a profit or ensure against a loss, but may help reduce risk and volatility in your portfolio. Diversification cannot eliminate the risk of investment.
With a traditional IRA, the contributions to the account may be tax-deductible but deductibility depends on your income and the earnings grow tax-deferred until withdrawn. Withdrawals prior to 59 ½ may be subject to a 10% federal income tax penalty and state income taxes (if applicable). A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first- time home purchase.
CRN-3627721-061021
1https://www.morningstar.com/articles/867690/reduce-taxes-with-strategic-asset-location
2https://www.investopedia.com/ask/answers/091715/how-often-do-mutual-funds-pay-capital-gains.asp
3Morningstar.com, Op Cit.
4Morningstar.com, Op Cit.
5 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.
6Morningstar.com, Op. Cit.
7 https://www.nerdwallet.com/article/investing/these-are-the-best-roth-ira-investments
8See, for example, https://www.fool.com/investing/2018/12/05/3-great-stocks-for-your-ira.aspx
10https://www.kitces.com/blog/reit-real-estate-investments-section-199a-qbi-deduction/
11Ibid.