When it comes to investment strategies, many investors are familiar with the concept of asset allocation. However, what often gets overlooked is the importance of asset location, particularly for wealthier investors. Asset location focuses on minimizing taxes to boost after-tax returns, making it a crucial component of financial planning that should not be ignored.
The Basics of Asset Location
Asset location leverages two fundamental principles. Firstly, not all investment accounts are taxed in the same way. There are tax-deferred accounts, such as traditional IRAs and 401(k) plans, tax-exempt accounts like Roth IRAs, and taxable accounts like traditional brokerage accounts. Each of these account types comes with different tax implications that can impact an investor’s overall returns.
Moreover, investment income is taxed differently based on the asset type. For instance, interest income is taxed at ordinary income tax rates, which can be as high as 37% for the highest earners. On the other hand, profits from long-term investments like stocks held for more than a year are taxed at lower federal rates, ranging from 15% to 20% depending on the investor’s income level.
By strategically placing high-tax or tax-inefficient investments in tax-preferred retirement accounts and favoring investments with more favorable tax rates in taxable accounts, investors can reduce their tax burden and increase their after-tax returns. This approach, known as asset location, can potentially boost after-tax returns by 0.05% to 0.3% annually, according to a Vanguard analysis.
For example, an investor with a $1 million portfolio evenly split between stocks and bonds across different account types could save $74,000 over 30 years by implementing asset location strategies. This highlights the significant impact that tax allocation can have on long-term investment performance.
Wealthier investors should be as focused on tax allocation as they are on asset allocation, yet many fail to prioritize this aspect of financial planning. By aligning tax allocation with asset allocation, investors can optimize their portfolio for tax efficiency and maximize their overall returns.
Advisors recommend placing bond investments in tax-deferred or tax-exempt accounts, as bond earnings are typically taxed as ordinary income. On the other hand, high-growth investments and long-term stock holdings are better suited for taxable accounts, while municipal bonds, which offer federal tax exemption, are ideal for taxable accounts.
Beyond the immediate tax benefits, diversifying across different account types can provide long-term tax flexibility. For instance, withdrawing funds from a Roth account in retirement can help avoid triggering higher Medicare premiums, as Roth distributions are not considered taxable income. Additionally, having funds spread across various accounts can prepare investors for uncertainties in future tax rates and account taxation policies.
The strategic allocation of investments across different account types can significantly impact an investor’s after-tax returns, especially for wealthier individuals. By incorporating tax allocation principles into their financial planning strategies, investors can optimize their portfolios for tax efficiency and enhance their overall investment outcomes.