Asset Allocation
Asset location is not talked about all that often. Before we do talk about it, let’s discuss what is talked about, asset allocation, and why that is important. Asset allocation is the different mix of asset types in your portfolio. Getting this right can help keep you diversified and help you reach your investment and retirement goals. It is critically important to get this right. If you get it wrong, then you may be putting your future at risk.
Asset Location
Less talked about is asset LOcation. This means, what type of account are you housing the different types of assets in your investment portfolio? If you owned munis, stocks, corporate bonds, and REITs in your portfolio, and you have a regular brokerage account, IRA, and a Roth IRA, how should you organize each account with which each of these? The mix of assets across all the accounts is your asset allocation; what specifically in each is your asset location.
Account Types
Getting asset location right can improve your long-term after-tax returns. IF you get it wrong, you’ll likely be okay, but it’s something that you most certainly do not want to ignore.
So let’s go over the three main investment account types—taxable, where you pay tax on all taxable interest income, dividends, and capital gains.
Then you have tax-deferred accounts like your traditional IRA and 401k, where you put in pre-tax dollars and then pay income taxes on all distributions.
Then you have your tax-exempt accounts, like a Roth IRA and a ROTH 401k. Here you are putting in after-tax dollars, and distributions are entirely tax-free.
Equities
Let's start with equities. So stocks, exchange-traded funds (ETFs), or mutual funds that an investor is holding for long-term growth, so for our discussion, at least one year. Returns from these investments are taxed at favorable long-term capital gains rates. Also, qualified dividends are taxed at reasonable rates of either 0%, 15%, or 20% based on your income and filing status. Nonqualified dividends are taxed at ordinary income tax rates. So since tax rates are generally more favorable, it makes sense to house long-term equities in taxable accounts.
It also is appropriate to hold them tax-deferred accounts. As you rebalance equities in a tax-deferred account over time, you will not be taxed on the gains or dividends as you go along. Still, of course, when you ultimately take distributions, you will be paying ordinary income taxes. With your IRA, you're in a partnership with the government, and the government is the controlling partner. Meaning, if we think tax rates are only going up, then keep in mind you might be paying more future tax than you expect. In taxable accounts, you at least have some control over taxes as you go along.
Equities are also perfectly appropriate in Roth IRAs. In general, your highest growth equities make sense in a Roth. Of all the equities you own across accounts, you may have a basket of dividend stocks or, more value, conservative-type stocks. Perhaps they should be in your taxable account. The stocks that you expect to have significant gains over time make sense in a Roth. If you are someone who likes investing in individual stocks that are speculative, but you have the conviction of massive future gains, then toss in a Roth, and you’ll never pay a dime on the profits.
Municipal Bonds
Next up, let’s talk about municipal bonds and municipal mutual funds. The interest received from these federally tax-free and often free of state and local taxes as well. So these securities do not belong in an IRA because you would essentially be turning something tax-free into something taxable. It also does not make sense in a Roth, in the sense that you are doubling your tax-free efforts needlessly. Save room in the Roth for assets that make the most sense.
REITs
Next, let’s talk about real estate investment trusts or REITs. Around 80% of dividends that REITS pay is generally taxed at ordinary income tax rates, which is not favorable. So REITs make the most sense in Tax-deferred accounts and Roth accounts. They will be okay in taxable accounts, but it’s not the most efficient approach.
Actively Trading Securities
Moving on, If you are someone who has a trading account where you buy and sell securities frequently, then this type of activity makes sense in a tax-advantaged account, either tax-deferred or tax-exempt. Trading like this generates frequent short-term gains (hopefully), which are taxed at ordinary income rates. There’s little sense in paying these taxes when you can go crazy with trading in an IRA or Roth IRA with no tax headache. Of course, if you did this to provide income, it may be different based on your particular situation.
Taxable Bonds
Finally, let’s cover taxable bonds, such as corporate bonds and taxable bond funds. These make the most sense in tax-deferred and tax-exempt accounts because pretty much all the income you receive is in the form of interest fully taxable at ordinary income rates. Obviously, not the best.
Bottom Line
Tax-efficient investing doesn’t require any particular skill, just the knowledge of what goes where. Get this right, and over time you improve your after-tax -returns.