Asset placement is a tax-saving approach that takes use of the fact that various kinds of assets have varying tax treatment. To optimize after-tax returns, an investor uses this method to identify which assets should be kept in tax-deferred accounts and which in taxable accounts. Who is eligible for this investment plan, how might asset location reduce taxes, and what is the best technique to position assets?
Achieving Optimal Asset Location
Although asset location delivers reduced taxes, it is not a substitute for asset allocation, which is the positioning of shares, funds, and other assets in a portfolio across various sectors to cushion market downturns. Only when you’ve determined the best asset mix for your portfolio can you place your assets in the most tax-efficient accounts.
The optimum location for an investor’s assets is determined by a variety of criteria, including the investor’s financial profile, current tax legislation, investment holding periods, and the tax and return characteristics of the underlying securities.
Because of the reduced capital gains and dividend tax rates, as well as the option to postpone profits, tax-friendly equities should be kept in taxable accounts. Riskier and more volatile assets belong in taxable accounts, both to delay taxes and to recover tax losses on underperforming investments sold at a recognized loss.
Index funds and exchange-traded funds (ETFs) are evaluated for their tax efficiency and, like tax-free or tax-deferred bonds, should be kept in taxable accounts. Taxable bonds, real estate investment trusts (REITs), and related mutual funds, as well as any mutual funds with substantial annual capital gains dividends, should be maintained in tax-deferred accounts.
Who Benefits From Asset Location?
Investors must have assets in both taxable and tax-deferred accounts to profit from this approach. Typically, asset placement benefits investors who utilize a balanced investment strategy that includes both equities and fixed-income assets. Investors with all-fixed-income or all-equity portfolios may gain, but not as much.
A typical investor with a balanced portfolio of 60% equities and 40% bonds may have assets in both taxable and tax-deferred accounts. Although the total portfolio of the investor should be balanced, each account does not have to have the same asset mix. Using the same asset allocation in each account overlooks the tax advantage of putting assets in the kind of account that will provide the greatest after-tax return.
For example, an investor with a 40% fixed-income and 60% equities asset mix would profit the most if the tax-deferred account holds 40% and the taxable account holds 60% of the total assets. Moving all fixed-income assets into the nontaxable account and all stocks into the taxable account will give the most advantage in this situation.
- Asset placement might be most beneficial to investors who utilize a balanced investing strategy that includes both equities and fixed-income assets.
- The advantage of asset placement is larger for older investors who are withdrawing cash from tax-deferred accounts or will be doing so shortly.
- When storing equities or equity mutual funds in a taxable account, investors benefit from reduced tax costs.
If an investor is or will be withdrawing assets from tax-deferred accounts, the advantage of asset placement is larger than for younger investors who have several years until they begin withdrawing cash.
Assume a standard individual retirement account has collected $20,000 in capital gains and dividends (IRA).The investor receives the whole amount as a distribution, which is then considered regular income. If the taxpayer is in the 35% tax rate, the investor will be left with $13,000 after taxes. If the investor had earned $20,000 in long-term capital gains and eligible dividends in a taxable account, the tax would have been just 15%, leaving him with $17,000.
Where a security should be placed is determined by how it is taxed.
How Asset Location Minimizes Taxes
Where a security should be placed is determined by how it is taxed. Long-term capital gains and eligible dividends are taxed at 0%, 15%, or 20%, depending on your income level. Meanwhile, taxable interest is recorded on Form 1040 and is taxed at regular income rates ranging from 10% to 37%.
Because most equity investments produce returns from both dividends and capital gains, investors who keep stocks or equity mutual funds in a taxable account benefit from reduced tax bills. If the identical capital gains and dividends were taken from a conventional IRA, 401(k), 403(b), or any form of retirement plan where taxes are paid on withdrawal, they would be taxed at the standard rate (up to 37%).
Bonds and other fixed-income assets produce a consistent cash flow. The same regular income tax rates of up to 37% apply to these interest payments.
The Bottom Line
The correct account in which to store investments for the most beneficial overall tax treatment is determined by asset location. The optimal location for a specific asset is determined by an investor’s financial profile, current tax rules, investment holding periods, and the underlying securities’ tax and return characteristics.
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