The Tax Benefits of Asset Location

by Kacie Swartz | Apr 16, 2018

Have you heard that real estate saying, “location, location, location”?   The same applies to investing.  Considering the tax efficiency of your savings vehicles and allocating your investments across them can make a real impact on your after-tax returns.  This strategy is called asset location.

Before we get into the details of asset location, the first step should be to build a portfolio diversified for your specific goals and financial resources, your acceptance of market swings (also known as risk tolerance), and length of time you’ll be invested (also known as time horizon).  Once you have decided on the asset classes that should be included in your portfolio, then consider asset location to maximize your tax efficiency.

Who Benefits from Asset Location?

Investors in a high tax bracket benefit the most from asset location.  High earners who expect to be in a lower tax bracket later should also consider asset location.  By delaying taxes, you will pay a lower rate in the future.  And finally, asset location takes time to make a big impact.  So plan to be invested at least ten years to see the most benefits.

What Types of Accounts?

There are three categories of tax treatment.  The capital gains, interest, and dividends created in “taxable accounts” are taxed every year.  “Tax-deferred” accounts like your 401k or Traditional IRA generally provide a tax deduction in the years you contribute.  Because you received a deduction in the year contributions are made, the future qualified withdrawals are taxed as ordinary income.  A “tax-exempt” account is your Roth IRA.  You don’t receive a deduction when contributions are made, but the qualified withdrawals are tax-free.  Both tax-deferred and tax-exempt accounts have rules about when you can take withdrawals.

How Does Asset Location Work?

Let’s use a real estate investment trust (REIT) as an example.  Assume you buy a REIT and hold the investment for ten years.  REITs are legally required to pay out at least 90% of taxable income, which we would deem less tax efficient.  Consider buying these securities in your tax-deferred or tax-exempt accounts.

As an alternative, let’s think about holding a mutual fund designed for long-term growth.  This investment is less likely to pay interest or dividends each year.  If held in a taxable account, you would be subject to long-term capital gains rates when you sell the investment, which are typically 15% or 20%. 

Using asset location isn’t a financial planning concept that occurs to many investors.  Working with an unbiased, fee-only advisor can help.  For more information about asset location or other financial planning concepts, please reach out to Morgan Stone or Kacie Swartz at info@stoneasset.com or 512-469-9152.