Many investors are familiar with the concept of asset allocation as a way of diversifying a portfolio to protect it in various types of markets and economic conditions. But a new term called asset location has emerged which should play an important part in the design of your portfolio.
Asset location refers to deciding which funds should be placed in taxable versus tax deferred accounts. Under the 2003 tax law, interest income and certain other investment income is taxed at ordinary rates which can be as high as 35%, while capital gains are taxed at a maximum of 15% and qualifying dividends are now just 15%. Even people in middle-income tax brackets might benefit from the preferential treatment for dividends and capital gains.
Since taxes reduce the net return that an investor receives, optimal location can make the portfolio more tax efficient and thereby boost the after-tax investment return.
Previously, stock funds were recommended for tax deferred accounts, while income based investments would go mainly in taxable accounts. There were several reasons for this; including the fact that income at retirement would normally come first from the taxable accounts. This would be the preferred approach if taxes were not a consideration, but the tax rate reductions for capital gains and dividends potentially change the equation today.
The tax law now suggests a shift of income investments, such as bonds, into retirement accounts to the extent practical. The taxable accounts should now have a greater growth emphasis, especially for people who don’t need much investment income. The overall asset allocation for an individual would not change; therefore, any shift between types of accounts would necessitate a compensating adjustment in another account.
Some general rules for placemen twithin accounts are as follows:
High return, highly tax efficient assets should go in taxable accounts. These would include stock index funds and tax-managed stock funds.
High return, less tax efficient assets,such as real estate and high-yield bond funds and many managed stock funds would go into the IRA or employer retirement account.
Low return assets can go in either taxable or tax deferred accounts. Thus, even though investments such as U.S. treasury bonds and short-term bond funds are taxed at ordinary rates and are not very tax efficient, they provide a relatively low return so it doesn’t matter too much where they are placed.
Despite the potential tax savings from optimal asset location, it’s generally not a good idea to overload any one area. The future is uncertain and tax laws seem to change with the political wind, so it is important to be flexible with your investment plan.
Of course, asset location does not apply t oinvestors who either have all of their investments in tax deferred accounts or all of their money in taxable accounts. But if you do have a choice – asset location should play a significant role in developing and maintaining a tax efficient portfolio.
Asset Location Can boost After-Tax Returns
December 12, 2008
By: Warren F. McIntyre,
www.visionquestfinancial.com
Re-printed with Permission
Many investors are familiar with the concept of asset allocation as a way of diversifying a portfolio to protect it in various types of markets and economic conditions. But a new term called asset location has emerged which should play an important part in the design of your portfolio.
Asset location refers to deciding which funds should be placed in taxable versus tax deferred accounts. Under the 2003 tax law, interest income and certain other investment income is taxed at ordinary rates which can be as high as 35%, while capital gains are taxed at a maximum of 15% and qualifying dividends are now just 15%. Even people in middle-income tax brackets might benefit from the preferential treatment for dividends and capital gains.
Since taxes reduce the net return that an investor receives, optimal location can make the portfolio more tax efficient and thereby boost the after-tax investment return.
Previously, stock funds were recommended for tax deferred accounts, while income based investments would go mainly in taxable accounts. There were several reasons for this; including the fact that income at retirement would normally come first from the taxable accounts. This would be the preferred approach if taxes were not a consideration, but the tax rate reductions for capital gains and dividends potentially change the equation today.
The tax law now suggests a shift of income investments, such as bonds, into retirement accounts to the extent practical. The taxable accounts should now have a greater growth emphasis, especially for people who don’t need much investment income. The overall asset allocation for an individual would not change; therefore, any shift between types of accounts would necessitate a compensating adjustment in another account.
Some general rules for placemen twithin accounts are as follows:
High return, highly tax efficient assets should go in taxable accounts. These would include stock index funds and tax-managed stock funds.
High return, less tax efficient assets,such as real estate and high-yield bond funds and many managed stock funds would go into the IRA or employer retirement account.
Low return assets can go in either taxable or tax deferred accounts. Thus, even though investments such as U.S. treasury bonds and short-term bond funds are taxed at ordinary rates and are not very tax efficient, they provide a relatively low return so it doesn’t matter too much where they are placed.
Despite the potential tax savings from optimal asset location, it’s generally not a good idea to overload any one area. The future is uncertain and tax laws seem to change with the political wind, so it is important to be flexible with your investment plan.
Of course, asset location does not apply t oinvestors who either have all of their investments in tax deferred accounts or all of their money in taxable accounts. But if you do have a choice – asset location should play a significant role in developing and maintaining a tax efficient portfolio.