by Kevin Kroskey, CFP®, MBA
How much attention do you pay to taxes related to your investments? Even for an astute investor, this is often a murky area at best. Now that interest rates are meaningful, it’s time to brush up and avoid unnecessary tax.
You may be familiar with the concept of asset allocation. Here you use diversification in an attempt to balance risk and expected reward by combining dissimilar asset classes or strategies to build an efficient investment portfolio. A nice way to think of it is skis and bikes at a mountain-side business. You sell skis in the winter and bikes in the summer for a smoother, diversified revenue ride.
Now that you have decided what you want to own (asset allocation), you must decide in what account type do you want to own it (asset location). Start with your three broad account types: taxable (joint or trust accounts as an example), tax-deferred (pretax 401K or traditional IRAs) and tax-free (Roth 401K or Roth IRA).
Taxable accounts are the most complex and are generally, but not always, the most tax inefficient. They generate 1099s each year and various tax rates are applied to dividends, interest and capital gains. Tax rates on qualified dividends and long-term capital gains are preferential and lower than tax rates on non-qualified dividends and interest, which are taxed at ordinary income rates.
In 2023, the highest federal rate for ordinary income is 37% while the highest preferential rate is 23.8%. US stocks that tend to generate little dividend income or are more index-like tend to be the most tax-efficient. So, these are generally ranked first to own in taxable accounts.
Your pretax accounts benefit from tax-deferred growth. No 1099 is generated until distribution when you then pay tax at ordinary income rates. Tax-inefficient assets are great for pretax accounts. Suppose you own a bond yielding 6% today. In the pretax account, you compound your growth at 6% until distribution. In a taxable account, your after-tax return would be 3.8% if in the maximum tax bracket with the tax bite causing less compounded growth over time.
Pretax accounts are great but a word of caution. Many successful people end up finding themselves in a similar or higher tax bracket in retirement. Plus, current tax rates are scheduled to increase in 2026 unless Congress takes action.
Tax-free Roths are great. It’s generally a good idea to put your highest expected return assets here. But contributions are limited. While you can convert your pre-tax accounts to Roth, you have to pay a tax toll to get them here.
Reasons to put tax-efficient stocks in taxable accounts:
- Equities receive capital gains treatment; bonds are taxed at ordinary income
- Capital gains are only due when realized; interest taxed yearly
- Tax losses can be harvested; the more volatile the asset, the more valuable the option to harvest losses
- Foreign tax credits received for foreign investments in taxable accounts only
- Ability to donate highly appreciated shares to charity and avoid gains while receiving a full deduction
- Stepped-up cost basis upon death so capital gains can be avoided
Who Benefits from Asset Location
Asset location benefits will vary based on a multitude of factors and will differ for each investor. A 2005 study by the late Dr. Gobind Daryanani, “A Generic Framework for Maximizing After-Tax Wealth,” quantified the potential benefits of an asset-location strategy and showed that a reasonable expectation is an increase of 0.20% each year to overall net investment returns. Supposing a $1 million portfolio, that’s $2,000 yearly. Your benefits may be greater if any of the following apply:
You currently pay a high marginal income tax rate: The higher the marginal income tax rate you currently pay, the bigger the potential benefits of asset location.
You expect to pay a lower marginal income tax rate in the future: If you expect your marginal income tax rate to be lower in the future than it is now, active asset location may allow you not only to defer your taxes but to reduce them as well.
You have significant assets in taxable accounts: The larger your taxable account, the more taxes matter and the greater the potential to take advantage of asset location.
You are investing for the long term: Asset location strategies generally take time to work. While small tax benefits may be realized year over year, sizable benefits may be realized by allowing potential tax savings to compound.
Asset location has always been somewhat of a free lunch for those capable of utilizing it. Yet when bond yields were lower, it mattered less. Today with higher interest rates and the inherent tax inefficiency of interest income, it matters a lot more.
If this is an area that is murky to you or your advisor is managing your taxable account with a myriad of assets other than tax-efficient equities, it may be time for a second opinion.
Tax & Wealth Management Services | 330.777.0688 | TrueWealthDesign.com
700 Ghent Road, Suite 100, Akron, OH 44333 | Ft. Myers | Naples | Pittsburgh | Youngstown
True Wealth Design
Kevin Kroskey, CFP®, MBA is the Founder of True Wealth Design, a wealth management firm with deep expertise in retirement, tax, and investment planning, helping successful families and individuals Plan Smarter and Live BetterTM
Opinions and claims expressed above are those of the author and do not necessarily reflect those of ScripType Publishing.
Read More: Minimizing Your Taxes with Asset Location Strategies