By Patrick S. Whalen, CFP®, CTFA
For those of us who live in California, which has a top income tax rate of 13.3%, it is possible to lose over 50% of your investment income to taxes. Fortunately, the negative impact of taxes on your financial plan can be reduced by carefully choosing which types of assets to hold in a retirement versus a non-retirement account. This concept is called “asset location”.
Asset location should not be confused with asset allocation. Your target asset allocation will specify what percent of your total combined accounts should be invested in various asset classes such as: large cap US stock, small cap US stock, foreign stock, and bonds. In contrast, asset location focuses on enhancing the results of your asset allocation strategy by selecting the ideal account to hold specific assets in. To explain another way, if you owned a store then your asset allocation decision would involve deciding what mix of products you wanted to make available for sale. Asset location would be the process of determining where in your store each item should be placed in order to maximize profit.
For the sake of clarity, I’m going to share some of the definitions that I will be using. When I refer to non-retirement accounts, I mean an account without tax advantages. Each year the account owner has to pay taxes on interest, dividends and capital gains that are produced by the investments within the account. Some of the more common accounts in this category include: brokerage accounts, mutual fund accounts, and revocable trust accounts.
Capital gains are the profits from sale of assets. In non-retirement accounts you can incur capital gains tax even if you have not proactively sold anything. Think about one of your mutual funds and then picture the manager of that mutual fund buying and selling stock or bonds within the fund. The tax consequences of purchases and sales within a fund flow-through to investors.
When I refer to retirement accounts but do not specify what type, I’m talking about both tax-deferred retirement and after-tax retirement accounts. Both kinds of retirement accounts shield the investments within it from being taxed on the dividends, interest and capital gains that are earned each year. By protecting your investments from taxation your asset are allowed to snowball into a larger sum than might be possible in a non-retirement account.
Tax-deferred retirement accounts provide a tax deduction when you make contributions into the account, but then tax you on any distributions that you take during retirement. Examples of tax-deferred retirement accounts include the 401k, Traditional IRA and 403b.
After-tax retirement accounts lack an initial tax deduction but then allow you to make withdrawals in retirement that completely escape taxation. Examples of after-tax retirement accounts include the Roth 401k and Roth IRA.
Investments to Prioritize for Non-Retirement Accounts
When selecting assets for your non-retirement accounts you should try to select assets that are tax-efficient. An asset that is tax-efficient will be able to provide investment returns that are not significantly reduced by taxes on dividends, interest and capital gains.
The percentage of assets within a fund that are sold and replaced each year is referred to as asset turnover. Funds with a low asset turnover are generally more tax-efficient because they create less capital gains for investors. ETF’s (Exchange Traded Funds) and mutual funds that focus on tracking broad based stock indexes, such as the S&P 500, are an example of an asset that has low turnover and therefore produces very little capital gains tax.
ETF’s are similar to mutual funds with regards to the assets that they can hold, however they are structured in a way that makes them more tax-efficient. The disadvantage of ETF’s is that you often have to pay a small commission when you buy or sell them. You will need to weigh the benefit of increased tax efficiency against the cost of commissions in order to determine whether an ETF is preferable to a mutual fund that has a similar strategy.
ETF’s and mutual funds that primarily invest in foreign stocks can be especially tax-efficient. The dividends from foreign stocks are sometimes taxed by their home country, regardless of what type of account holds the assets. US tax law has provisions that allow investors to take a tax-credit for the taxes that were already paid to the foreign government. This tax-credit can only be used if the assets are held in a non-retirement account.
Municipal bond funds can also be highly tax efficient and may make sense for people who are in high tax brackets. Whether municipal bonds are right for you will depend on many factors such as your income level, what types of municipal bonds are purchased and whether you are impacted by the Alternative Minimum Tax. If you choose to use an ETF or mutual fund as a vehicle to invest in municipal bonds then you will want to pay attention to the degree of asset turnover within the fund.
Investments to Prioritize for Retirement Accounts
For most people, it is best to hold your most tax-inefficient assets within a retirement account. An asset is tax-inefficient if holding it in a non-retirement account would cause a relatively large amount of its investment returns to be lost to taxes. Tax-inefficient assets are shielded from taxation as long as they are owned within a retirement account.
One way that you can identify an asset as tax-inefficient is if it distributes a large amount of ordinary income. Funds that invest in high yield corporate bond and REITs (Real Estate Investment Trusts) are two examples of assets that produce a significant amount of ordinary income. Income that is categorized as “ordinary” is taxed at a higher rate than other types of investment income, such as qualified dividends and tax-exempt interest.
In general, I’m not a fan of owning actively managed funds, but if you do wish to own actively managed funds then a retirement account is the place to own them. Actively managed funds in particular tend to have a high turnover of assets because the fund manager is buying and selling in an attempt to outperform the market. In a non-retirement account, the frequent buying and selling of assets within the fund is likely to create a significant capital gains tax liability, but in a retirement account you are protected.
What about after-tax retirement accounts, such as a Roth 401k or Roth IRA? You could certainly use them for holding tax-inefficient assets. Another option is to maximize the potential for tax-free growth by using after-tax retirement accounts to hold the portions of your portfolio that are expected to appreciate the most. As you may recall, the retirement distributions from these types of accounts have the ability to escape taxation. Stocks typically outperform bonds; therefore you may prefer to hold stock based investments in your Roth 401k or Roth IRA.
Two types of accounts that this article is not intended to address are irrevocable trusts and annuities. Both have unique considerations that are beyond the scope of this discussion.
The reality is that not everyone has a proportion of balances between retirement accounts and non-retirement accounts that allows them to fully utilize the strategy that I have presented. In order to meet your target asset allocation it may be necessary to buy assets in an account that is less than ideal. Asset allocation should take priority over asset location.
For most people it makes sense to contribute as much as possible to retirement accounts. I would not want to see someone add less money to a retirement account for the sake of asset location, unless they had done some careful and detailed analysis first.
The benefits from this strategy will tend to be more modest in low interest rate environments. Economic cycles and tax policy will have an impact on whatever methodology you choose and there is no one strategy that is best for all people. Please carefully evaluate any strategy, including this one, before taking action with your own portfolio. A good financial planner can help you create both an asset allocation and asset location strategy that is tailored to your unique needs.
About the author:
Patrick S. Whalen, CFP®, CTFA is a fee-only financial planner located in the Los Angeles area and is the principal of Whalen Financial Planning.