Asset Location for Tax Optimization

A critical distinction between individual and institutional investors is the relative importance of after-tax returns. Many institutions, such as endowments and pension funds, are tax-exempt, and therefore not concerned with potential tax consequences in their portfolios. Individual investors “only eat after-tax returns” and therefore should think differently. While this applies to many investing concepts, ranging from active vs. passive to choosing alternative investments, today we will discuss on how to optimize after tax returns with different account types – also known as asset location.

Different Account Types

Tax-Deferred - (401k, Traditional IRA)

Tax-deferred accounts allow you to deduct your contribution from your taxable income, but future withdrawals from the account will be taxed at your ordinary-income rate. This provides a strong incentive for individuals to prioritize saving in their tax-deferred accounts.

In retirement, individuals will likely generate less taxable income, finding themselves in a lower tax bracket. If you are currently in a high tax bracket, it is strongly recommended to maximize contributions in tax-deferred accounts to minimize their current tax obligations.

Tax-Exempt – (Roth Accounts, HSA, 529 Plans)

Tax-exempt account contributions are made with after-tax income. The trade-off for funding these accounts with after-tax dollars is that investment gains are not taxed upon withdrawal.

In retirement, individuals benefit from keeping taxable income below a certain threshold to stay in a lower tax bracket. Because qualified withdrawals from tax-exempt accounts do not count as taxable income, investors with tax-exempt accounts can keep actual income higher while minimizing taxable income, potentially keeping them in a lower tax bracket.

Taxable Accounts

Traditional brokerage accounts are funded with after-tax dollars and are subject to relevant capital gains and income taxes.

Optimizing Asset Location

The guidelines below are a starting place for asset location

Tax Deferred – Generally, we want to hold lower expected return securities in tax-deferred accounts, along with securities where income is a high proportion of the total return. This includes, but is not limited, taxable bonds and REITS. Higher turnover active equity strategies can also be held in a tax-deferred account to minimize tax drag.

Tax-Exempt – Because all investment returns are tax-free, we want to hold the highest expected return assets – equities, especially higher turnover active strategies.

Taxable – Lastly, we want to hold tax-efficient assets in taxable accounts. Municipal bonds are tax-exempt and a good choice for taxable accounts, as is market-capitalization weighted equity index ETF exposure.

Individual Considerations

Tax Bracket – What tax bracket you are in now, along with your expected tax bracket in retirement, will impact your individual considerations. The higher your tax rate, the greater the potential benefits of optimizing your asset location.

Asset Allocation – If you are concentrated in a single asset class, as a young person with a multi-decade time horizon might be concentrated in equities, the benefits of optimizing asset location are smaller. If you own a balanced portfolio, the benefits of optimizing asset location are greater.

Asset Breakdown by Account Type - If your investable assets are more evenly dispersed across account types, the benefits of optimizing asset location are greater. Conversely, if your investable assets are concentrated in one account type, the potential benefits of optimizing asset location are lower.

The Bottom Line

Asset location plays an important role maximize your after-tax investment returns. For individual investors, the potential tax obligation of any investment should be considered when selecting any investment and choosing which type of account to hold it in. If you need an opinion on your financial planning, investing, and tax optimization, please feel free to reach out to our team at Invariant.