After designing an asset allocation near the efficient frontier and rebalancing periodically, the next step is to design a plan for tax-efficient asset location across your accounts.
Asset Location is the strategy of purchasing investments in the accounts where the tax treatment will ultimately have the optimum after-tax return.
Assuming you have the option of purchasing investments in either an IRA or a brokerage account, there is significant benefit to locating highly-appreciating stock investments in your brokerage account and interest-generating bond investments in your traditional IRA.
Imagine your annual income subjects you to a 25% federal income tax and a 5% state income tax. This also subjects you to a 15% capital gains tax and a 5% state capital gains tax. You expect to be in the same tax brackets over time.
Your asset allocation calls for investing $10,000 in a stock sector which has an expected mean annual appreciation of 10% and also calls for investing $10,000 in a bond sector which is expected to pay 3% in interest. You have the free cash in either account to make these purchases.
Regardless of where you put them, the stock will grow by $1,000 and the bond will generate $300 of interest.
In your IRA, because you will ultimately have to pay a 30% ordinary income tax on withdrawal, the stock growth generates $300 of ordinary income tax owed one day and the bond interest generates $90 of ordinary income tax owed. As a percentage of your appreciation, the tax burden of your IRA dampens your after-tax stock returns by 3.0% and your after-tax bond returns by 0.9%..
Meanwhile, in your brokerage account, the stock growth generates $200 of capital gains tax owed because investments purchased in your brokerage account ultimately have to pay a 20% capital gains tax when the gain is realized.
And the bond interest in your brokerage account generates $90 of ordinary income tax owed, as bond interest is always taxed at ordinary income tax rates.
As a percentage of your appreciation, the tax burden of your brokerage account dampens your after-tax stock returns by 2.0% and your after-tax bond returns by 0.9%.
There is a 1.0% after-tax benefit to locating the stock investment in your taxable account rather than putting it in your traditional IRA where capital gains will ultimately be subject to ordinary income tax rates. And the bond investment sees a slight benefit to being in the traditional IRA because the tax, which would have had to be paid immediately if the brokerage account, is deferred in the traditional IRA until you withdraw it.
In this simple example, the asset location boosts after tax returns by 0.50%.
Roth accounts add more tax-saving asset location strategies. If either of these investments were purchased in a Roth account, no tax would be owed, either on interest or appreciation.
The strategy and the savings of asset location is dependent on the specific situation of the individual investor. But when all of the asset location strategies have been employed and compounded over time we estimate that the average after-tax value of asset location is about 0.76%.
The science of asset location suggests that several commonly held ideas are in fact misconceptions.
Some investors suggest that people buy stocks in their traditional IRA so that they can grow “tax free” meanwhile keeping cash in their taxable account. This ignores the fact that ultimately everything in their traditional IRA will be subject to ordinary income taxes.
Other investors suggest waiting until the end of the year before taking the required minimum distribution (RMD) from their IRA based based on the similar misconception that letting the RMD grow “tax free” as long as possible in the IRA is beneficial. In fact letting stocks grow in your traditional IRA increases the amount that will ultimately be subject to ordinary income tax rates. If your tax burden is always equal, it is better to get money out of your traditional IRA and into a brokerage or Roth account.
It is because of the tax savings of asset location that asset conversion is important. The tax savings of Roth conversions could be thought of as just one method of moving an asset’s location. A Roth conversion moves the location of assets from a traditional IRA subject to ordinary income tax rates to a Roth IRA where growth is tax free. Required minimum distributions move money from a traditional IRA where they are taxed as ordinary income to a taxable brokerage account where they are only subject to capital gains tax rates. But if there is any room in your current tax bracket, rather than taking out more than the RMD than is required, better to satisfy your RMD and then do additional Roth conversion.
Similarly, if you have a choice of funding Roth IRAs or keeping the money in your taxable account, funding your Roth IRA is better even if you can’t afford it. Doing so you can convert your taxable savings into Roth IRA savings. Asset location is why you should contribute to your spouse’s Roth IRA as well. And if you are over the income limits you should fund your Roth IRAs through the means of a backdoor Roth IRA if possible. Asset location also suggests that you contribute both to your Roth 401(k) at work as well as contributing to you Roth IRA each year. If your employment allows, you may also be able to contribute to a Roth 457 account. With all the possible types of accounts, it is important to know which retirement accounts you should fund each year.
To be clear, while proper asset location results in a portfolio which is well balanced, it may very well result in individual accounts which are not well balanced. Certain types of investments are best suited for certain types of accounts.
Here are some of the considerations when locating assets in different types of accounts.
For simplicity’s sake I will abbreviate the three types of accounts as traditional, taxable, and Roth. While there are many other types of accounts, such as college 529 savings or healthcare savings accounts, the principles of asset location can be generalized to these three types of accounts.
As we have seen, interest-generating bonds are best put into traditional accounts. This is also true of bond funds as the slower growth dampens the tax burden you accumulate in your traditional account. Bonds should be in a taxable account as a good second choice for asset location. Short term bonds are a good place to stage money to support the next year’s worth of outgoing cash flows. Roth accounts should be the last type of account to purchase bonds.
Like bonds, real estate investment trusts (REITs) are also best kept in traditional accounts. By law, REITs must distribute more than 90% of their profits as dividends which are taxed if they are not in an IRA.
Stocks are best put into Roth or taxable accounts. The stocks with the highest expected mean return are best put into Roth accounts where it will never be taxed again. Fast growing stocks may be the most volatile stocks, so you are subjecting your Roth accounts to the greatest volatility. That is appropriate since Roth accounts should be the very last accounts used in retirement. Since Roth accounts have the longest time horizon they can afford to have the most volatile investments. The fastest growing investments might include sectors such as emerging market stocks and small cap stocks.
Stocks are appropriate in taxable accounts as well. Stocks in taxable accounts are subject to capital gains taxes when they are sold and the capital gain is realized. When the stock appreciates well, you may find that the entire position now has a large unrealized capital gain. Selling that stock will realize the capital gain and subject the investor to capital gains taxes. If the entire allocation to a specific sector of your asset allocation is in the taxable account there may be no way to rebalance your portfolio without realizing capital gains. There is a trade off between realizing capital gains and letting your portfolio grow out of balance. But there are also several ways of avoiding having to make that choice.
Limited Partnerships or MLP are also best held in taxable accounts. This type of investment can generate more than $1,000 of annual unrelated business-tax income or UBTI which can be taxed even when it is held inside an IRA.
Foreign stock, when held in a taxable account, allows a tax credit of the foreign stock tax paid. Since this is a tax credit, the savings can be significant. For example, for $50,000 of dividends a client might receive a $3,500 tax credit. This can make it advantageous to hold foreign stock in a taxable account.
Also best held in taxable accounts are bond holdings comprised primarily of tax-free bonds. It may seem obvious that there is no advantage to holding tax free bonds in a qualified account. But some balanced funds or aggregate bond funds may include tax-free bonds. Breaking these components apart and locating each component in the optimum type of account could produce a significant savings.
Investors can anticipate the potential future problem they may have with capital gains. If they purchase a a large amount of a sector of the portfolio they can also purchase some of that sector in the traditional or Roth accounts where appropriate. If traditional accounts are going to hold more than just bonds on account of your overall asset allocation, holding a portion of each sector allows you to sell that portion in the traditional account when that sector needs to be trimmed in order to rebalance your over all portfolio allocation. Rebalancing your portfolio may even result in buying and selling the same security.
Imagine the stock portion of your portfolio has grown and rebalancing now suggests that you sell stocks and buy bonds. You and your spouse have also just added $13,000 by funding your Roth IRA accounts by $6,500 each. How can you invest the additional $13,000 appropriately without purchasing bonds in your Roth accounts?
If you look at your traditional IRAs, you may find some stocks in sectors which need to be trimmed. If you over-trim these sectors by $13,000 more than they need to be trimmed those sectors will now be under allocated by $13,000. Purchase those exact same sectors in your Roth accounts. And with the money generated in your traditional accounts by the sale, purchase bonds. This stock-bond shuffle of assets between accounts results in a more tax efficient asset location which should boost after-tax returns going forward. But it does so by buying and selling the exact same stock securities the exact same day.
Ultimately unrealized capital gains may build up in taxable accounts. There are many ways to optimize returns even as unrealized capital gains is building up. Capital losses can be matched with gains. You can use appreciated stock for your charitable giving. You can intentionally realize some capital gains each year at the zero or 15% federal capital gains tax rate. You can give appreciated stock to family members who can sell for zero percent federal capital gains tax.
Asset location can be greatly enhanced by asset conversion. Currently no robo-investing handles both asset location and asset conversion.
Exact asset location depends on the percentage of a portfolio held in each of the three types of accounts as well as the percentage of the portfolio which is to be allocated to each selected sector. But the boost in after-tax returns is well worth the effort.
Photo used here under Unsplash Creative Commons Zero.