How Asset Location Can Help Save on Taxes

Does it matter from a tax perspective which accounts you use to house your investments? The answer is a resounding "yes." Account types, like assets, have different tax characteristics. By matching certain accounts with certain assets, you may be able to realize significant tax savings and boost your investment returns.

This strategy is called asset location, and while all investors may be able to benefit from strategically locating their assets for tax efficiency, households in higher tax brackets stand to gain the most.

To fully appreciate the power of asset location, it's important to remember how assets held in the three main account types are taxed:

1. Taxable (taxable brokerage accounts)

• Contributions: No upfront tax deduction.
• Income and growth: Interest, non-qualified dividends, and investment held for a year or less are taxed at the ordinary income rates. Investments held for over a year and qualified dividends are taxed at the lower long-term capital gains (LTCG) rates.
• Withdrawals: Any gains on sales are subject to capital gains taxes.

2. Tax-deferred (traditional IRAs, traditional 401(k)s)

• Contributions: Qualified contributions are non-taxable.
• Income and growth: Income and capital gains are not taxed until withdrawn.
• Withdrawals: Qualified withdrawals are taxed at ordinary income rates.

3. Tax-exempt (Roth IRAs and Roth 401(k)s)

• Contributions: No upfront tax deduction.
• Income and growth: Not subject to additional taxes if withdrawals are qualified.
• Withdrawals: No taxes on qualified withdrawals. 

An asset location strategy seeks to manage your total tax burden by pairing tax-inefficient investments with tax-advantaged accounts and tax-efficient investments with taxable accounts.

Tax-inefficient assets are those that generate regular taxable events, which produces a tax drag on returns, eroding wealth annual and overtime. These include:

• Core bonds, which issue regular income payments.
• High-yield bonds, which also generate regular, potentially higher income. 
• Real estate investment trusts (REITs), which must distribute at least 90% of their income to shareholders.
• Actively managed funds with high turnover, which generate more taxable distributions than passively managed (index) funds.
• Investments you plan to hold a year or less, the gains on which are taxed as ordinary income.

By using a tax-deferred or tax-exempt account to invest in these assets, you can shelter their distributions from annual taxes, allowing the money to stay invested and continue generating potential returns until you're ready to withdraw it in retirement.

So, why not just put all your assets in tax-advantaged accounts? Because they all have annual contribution limits, and some also have income restrictions. This means that wealthier investors must turn to taxable options such as brokerage accounts if they want to sock away more money for retirement.

Fortunately, some assets are relatively tax-efficient even when held in a taxable account. Such assets include:

• Municipal bonds, which may generate tax-free interest.
• Index funds and exchange traded funds (ETFs), which may limit capital gains.
• Tax-managed mutual funds, who's mangers use strategies to try and limit the realization of capital gains.
• Stocks that generate qualified dividends, which are taxed at more favorable rates.
• Investments you plan to hold for more than a year, which are subject to the lower long term capital gains tax rates.

Locating your investments in a tax-efficient manger can ultimately help reduce your tax drag and leave you with more money after to taxes to reinvest or to provide for your living expenses.

Just how effective is asset location?

Our research indicates that following an asset location strategy can boost annual after-tax returns by 0.14 to 0.41 percentage points for conservative investors in the mid to high income tax brackets. (Conservatively allocated portfolios tend to invest more in bonds, where disparate tax treatments can have the most impact.) For example, a retired couple with a $2 million portfolio ($1 million in a taxable account and $1 million in a tax advantaged account) could potentially see a reduction in tax drag that equates to an additional $2,800 to $8,200 per year depending on their tax bracket.

It doesn't take a lot of extra work to potentially realize these benefits. In fact, for retirees in the highest tax bracket, approximately 90% of the potential extra return from asset location comes from just two specific moves:

1. Consider switching to municipal bonds instead of taxable bonds in taxable accounts. Higher-income investors tend to benefit more from Muni bonds because of the bigger tax exemption they receive, which boosts their tax-equivalent yields above those offered by taxable bonds.
2. Consider switching to passive stock funds in taxable accounts and active stock funds in tax-advantaged accounts. Even when held for long periods, actively managed mutual funds can carry a higher tax burden if active trading within the fund leads to capital gains distributions at year-end.

This approach is all well and good when setting up a portfolio from scratch, but what can you do for accounts that currently hold the "wrong" assets from an asset-location perspective? That's the case for many investors who have implemented a single asset allocation across all their taxable and tax-advantaged accounts (a common, easy-to-follow practice).

In tax-advantaged accounts, you can buy and sell investments without incurring an immediate tax hit. But that's not the case with taxable accounts, where asset sales can generate significant tax liabilities. For this reason, the better approach for a taxable account might be to strategically replace those assets over time rather than selling them immediately. For example:

• Look for opportunities to strategically harvest losses, which will help offset some income taxes and free up cash to reinvest according to your asset location strategy.
• If you have automatic reinvestment of interest and dividends turned on, consider turning that off and manually reinvesting that income into more tax efficient assets.
• Remove tax-inefficient assets from your taxable brokerage account as part of your annual income withdrawals.

While implementing an asset location strategy, just be careful to maintain your current risk exposure. If you sell assets in your tax-advantaged accounts without being able to quickly replace them in your taxable accounts, your asset allocation could get out of whack.

As with most things tax-related, don't let the tail wag the dog—focus first on maintaining your risk profile before making moves toward tax efficiency.

Due to the complexities involved with such decisions, not to mention the potential for near- and long-term tax consequences, it's best to work with a tax or wealth advisor when considering an asset location strategy. They can help make sure your portfolio is positioned for maximum tax efficiency—and that any moves in pursuit thereof don't have undesirable side effects.