By Wade Monroe, Melissa Linn and Lisa Featherngill
Asset location refers to the strategic placement of financial assets within the appropriate type of account to minimize income taxes and thus increase the after-tax rate of return. The appropriate asset allocation is a significant factor in maximizing returns relative to your risk tolerance. The purpose of asset allocation is to create a diversified portfolio that balances risk and return based on an investor's goals and objectives, risk tolerance, and time horizon. The location of those investments in your overall accounts can further increase your net worth by utilizing the tax efficiency strategy of asset location.
Asset location refers to the strategic placement of financial assets within the appropriate type of account to minimize income taxes and thus increase the after-tax rate of return. The appropriate asset allocation is a significant factor in maximizing returns relative to your risk tolerance. The purpose of asset allocation is to create a diversified portfolio that balances risk and return based on an investor's goals and objectives, risk tolerance, and time horizon. The location of those investments in your overall accounts can further increase your net worth by utilizing the tax efficiency strategy of asset location.
There are three main types of accounts where assets may be located:
- Tax deferred accounts are traditional retirement accounts that are funded with pretax dollars. These include retirement plans such as 401(k)s, 403(b)s and IRAs. The funds in the account grow tax-free. When assets are withdrawn, all principal and growth from the account are typically taxed at ordinary income tax rates.
- Tax-exempt accounts such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s are funded with after-tax dollars and continue to grow tax-free. When assets are withdrawn, principal and growth are typically returned tax-free. Health savings accounts (HSAs) fall into this group. HSAs are funded with pretax dollars and are exempt from future income taxes if the assets are used for qualified medical expenses.
- Taxable accounts such as traditional brokerage accounts are non-qualified accounts that are funded with after-tax dollars. Individuals recognize interest, dividends, and capital gains on an annual basis and may withdraw funds anytime without penalty.
Other factors that impact investment location include:
- Cash flow needs — Accessing tax deferred or tax-exempt retirement accounts before retirement at age 59 ½ can result in penalties. If assets are needed to supplement cash flow, investments should be in a taxable investment account.
- Current marginal tax rate — If you are currently in a high tax bracket consider placing the fixed income portion of your portfolio in a tax deferred or tax-exempt account. If you are currently in a low tax bracket and have access to a Roth IRA or Roth 401(k), you can allocate after-tax dollars and avoid future taxes at a potentially higher rate. Maximizing your contribution to your retirement plan annually provides the opportunity for greater growth over time and potential contributions by your employer.
- Future expected marginal tax rate — If you don’t anticipate a need to access funds and expect to be in a lower tax bracket post retirement, consider allocating funds to a tax-deferred account. This will allow you to defer taxes for an extended period, enjoy pre-tax investment returns and potentially have a lower tax liability post retirement.
- Taxability of investments — In general, bonds generate ordinary income on an annual basis. The top ordinary tax bracket in 2023 is 37%. Equities can generate tax preferential dividends and be treated as long-term capital gains at federal rates that top out at 20% in 2023. Alternative investments also tend to generate ordinary income in the top bracket in 2023 of 37%.
- Asset purpose – Are you investing the assets for you to live on today or in retirement or are you growing assets for the next generation? Your anticipated lifetime needs can affect where assets are located for short and long-term planning.
- Retirement plan funding – during your working years, there are maximum amounts that can be funded into retirement plans. Any excess funds will need to be invested in a taxable investment account.
While considering the accessible types of accounts and the other factors described above, there are strategies to minimize the tax impact to your portfolios over your lifetime.
The first step to building any portfolio is deciding on the appropriate asset allocation. This is the process of ensuring your asset mix reflects the appropriate risk tolerance, time horizon and stated investment objectives.
Once the appropriate asset allocation has been determined, you can begin the process of asset location. The chart below highlights the types of securities, types of accounts, and considerations for placing each type of security in each type of account.
| Security Type | Account Type | Account Type | Account Type | Reason |
|---|---|---|---|---|
Taxable Account |
Tax-deferred |
Tax-exempt |
||
Taxable Bonds |
X |
X |
The income received from taxable bonds is taxed at ordinary tax rates which can be as high as 37% in 2023. |
|
Municipal Bonds |
X |
The income received from municipal bonds is generally tax exempt. |
||
Individual Stocks |
X |
X |
Individual stocks held for more than 1 year will be taxed at the capital gains rate when sold for a gain. |
|
Actively Traded Mutual Funds |
X |
X |
Actively traded mutual funds distribute their internal capital gains to shareholders which is then taxable at capital gains tax rates. |
|
ETF Index Funds |
X |
Index funds are passive investment vehicles, meaning they are not as actively traded like mutual funds and typically generate less in capital gains distributions due to the nature of trading. |
||
Real Estate Investment Trusts (REITS) |
X |
X |
X |
REIT income is generally taxed at ordinary income rates, though qualified REIT income can be taxed at 0%, 15% or 20%, depending on your AGI. There is also the potential for capital gain taxes |
Let’s review a few examples.
Example 1: A 65-year-old investor has an IRA with $1 million and a taxable brokerage account with $500,000 of investments including $200,000 in unrealized capital gains. She needs $100,000 for home renovations. If she takes the money from her IRA, the distribution will be taxed at the ordinary income rates. Assuming she is in the 37% bracket (and ignoring net investment income tax), she would need to distribute $158,700 ($100,000/.63) to net the $100,000 required for the renovation.
Alternatively, she could take the money from her taxable brokerage account and would only need to take out $109,000 to net the required $100,000. The tax is much lower because only 40% of the sale proceeds are taxable due to the basis in her investments of $300k. The taxable portion is taxed at the capital gains rate.
Taking the money from her taxable brokerage account and paying the 20% capital gains tax instead of ordinary income tax provides $49,700 in tax savings on the distribution. Note that this may increase required distributions from the IRA in later years, which could affect the cost of Medicare and increase taxability of Social Security benefits.
Example 2: John and Sally are 45 and high earners in the top tax bracket of 37%. They pay 20% tax on qualified dividends and long-term capital gains. Their asset allocation is 50% equity and 50% fixed income. They have $500,000 in Sally’s retirement plan and $500,000 in a joint brokerage account. They want advice about which accounts should hold which type of investments. Assume they will invest the fixed income portion in a diversified portfolio of intermediate term taxable bonds with an average yield of 4%. Assume the other $500,000 is invested in large cap core equities with a 2% dividend yield and 6% annual growth. Assume no distributions, all earnings are reinvested and no withdrawals. Also ignore the impact of volatility and the net investment income tax.
The following chart shows the value of the retirement plan and brokerage account when they turn age 67 under 3 scenarios.
First, the brokerage account is invested 100% in the equity portion of their portfolio (thus, the retirement plan is 100% fixed income). Second, assume the brokerage account is invested 100% in fixed income (the retirement plan is 100% equities). Third, assume both the brokerage account and retirement plan are invested 50% in each fixed income and equities. Also assume that taxes on the income earned in the brokerage account is paid from the account each year.
| Scenario | Retirement Plan Balance | Brokerage Account Balance | Tax on Brokerage Unrealized Gains | Future Income Tax on Ret. Plan | Total Assets |
|---|---|---|---|---|---|
Equities in Brokerage |
$1,232,358 |
$2,695,580 |
($346,671) |
($455,972) |
$3,125,295 |
Equities in Ret. Plan |
$2,935,732 |
$886,273 |
0 |
($1,086,221) |
$2,735,785 |
50% in each account |
$1,909,875 |
$1,585,289 |
($126,564) |
($706,654) |
$2,661,946 |
You can see that after 22 years of earnings, the total assets are significantly higher when tax efficient investments are located in the brokerage account and investments that generate income taxed at ordinary rates are located in retirement plans.
Appropriate asset allocation is a key part of your investment strategy. Using asset location in conjunction with your asset allocation can minimize income taxes annually and over time and help you reach your goals more quickly and efficiently.
About the authors
Wade Monroe: Wade is Senior Investment Strategist at Comerica Wealth Management. He develops and implements custom investment solutions for high-net-worth individuals, families, business owners and institutions, based on a deep foundation of financial planning and understanding of client needs. He utilizes Comerica’s vast investment research capabilities to tailor investment portfolios to the complex needs of each individual client. Before joining Comerica in 2022, Wade was a portfolio manager for an RIA and served as a voting member of the investment committee. He holds his CFP® and CIMA®.
Melissa Linn: Melissa is a Senior Wealth Planning Strategist who specializes in having strategic conversations with clients to maximize opportunities and minimize unintended consequences. She develops customized wealth planning solutions for business owners, executives, and other high net worth clients. She joined Comerica in 2021 to cover the Southeast region after spending almost 16 years at Wells Fargo/Wachovia. Before joining Wachovia in 2006, Melissa worked at Deloitte and Stancil & Co focused on tax compliance and planning with high-net-worth families and business owners.
Lisa Featherngill: Lisa leads a team of experienced and credentialed wealth planning specialists who develop customized wealth planning solutions for business owners and other high net worth clients. She joined Comerica in 2021 to lead the team and enhance the Wealth Planning offering after spending almost 25 years at Wells Fargo/Wachovia/First Union in planning leadership roles. Lisa spent the first 11 years of her career at Arthur Andersen in Washington, D.C., where she was a member of the Personal Financial Planning and Family Wealth Planning teams.
Editor's Note: The content was reviewed for tax accuracy by a TurboTax CPA expert for the 2022 tax year.
