Author: Brent Lemieux CFA® CPA

This post is part of our series on how to save tax on investments.  By making more tax conscious investing decisions, we give ourselves the opportunity to earn a higher after- tax return without really changing the overall composition of our portfolios.  One strategy for reducing taxes, therefore boosting  after- tax returns, is called asset location.

Asset location explained

Asset location (a.k.a. tax location) is the practice of placing different assets, or different asset classes, in the type of account that maximizes the after- tax return of the entire portfolio. If this strategy is done  correctly, you give yourself the potential to earn the same return before tax and a higher return after- tax, all without taking on any additional risk.

How is this possible?

The two factors that make asset location a viable strategy are:

• Certain types of accounts (i.e. Traditional IRA, Roth IRA, Taxable Brokerage, etc.) are treated differently under US tax law.
• Certain asset classes (i.e. US Stocks, High Yield Bonds, Government Bonds, etc.) are taxed at different rates.

To illustrate how this works in the real world, let’s consider a simple example. Jane has $100,000 saved for retirement.  $50,000 of this is in a taxable brokerage account and $50,000 is in a traditional IRA.  Jane invests 50% of her money in US Stocks and 50% in taxable bonds.  The default would be to invest $25,000 in each of the asset classes in each of the accounts.  However, this could be very inefficient.  Unless Jane is a low income earner, it is likely that her tax rate on ordinary income is much higher than her capital gains and qualified dividend tax rate.

Let’s assume Jane pays 28% in Federal tax on ordinary income and 15% on long term capital gains and qualified dividends.  Jane could keep her before tax investment return the same and boost her after-tax return simply by shifting all of her taxable bonds to her IRA and all of her US Stocks to her taxable account.  Her overall portfolio asset allocation still looks the same .  That is, she still has 50% in US Stocks and 50% in Taxable Bonds, but her tax efficiency has improved.  Her ordinary income producing bonds are now in her tax deferred IRA, so she won’t have to pay tax on them until she withdraws funds from her IRA.  Now she will only have to pay the lower tax rate on qualified dividends and capital gains.  It’s worth noting that capital gains tax is only incurred when assets are sold at a gain, so she has control over when it will be paid by timing her gains.  Another plus!

As we introduce more account types and more asset classes, asset location gets quite a bit more complex. We are here to help.  If you are unhappy with the amount of tax you are paying on your investments, contact a Windward Advisor today!

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