New tax law may call for tweaking strategy but probably not big changes.
Asset allocation comes first, then comes asset location.
It’s the often overlooked strategy of placing investments in the right accounts to minimize taxes. And while the anticipated new tax law may affect the strategy somewhat, don’t wait for passage to act.
Most asset-location strategies that work today will work just as well in 2018 under almost any scenario, though you may need to make some adjustments.
Asset location means you hold, or locate, tax-efficient investments in taxable accounts and tax-inefficient investments in tax-deferred or tax-free accounts. While the concept is simple, execution can be complex.
It starts with viewing your assets as one integrated investment portfolio, instead of as separate accounts. By considering all of your accounts together, you can make good decisions about which accounts will hold which types of assets.
To make it work, you need significant assets in both taxable and tax-deferred accounts. The more types of retirement accounts you have — such as an IRA, Roth IRA, SEP IRA, profit-sharing plan, 401(k) or 403(b) — the more opportunities you have for effective asset location.
There are clear rules about where you should hold tax-inefficient investments. REITs, for instance, are tax-inefficient because they produce relatively large amounts of ordinary taxable income. REIT funds should be held in retirement plans whenever possible.
Taxable bonds are also tax-inefficient, but since they’re valuable for meeting medium-term needs, they can be spread among both taxable and retirement accounts to better manage cash withdrawals.
If your tax bracket is high enough, invest in tax-free municipal bond funds instead. That way, you can get tax efficiency while meeting your allocation to low-risk investments. Municipal bonds belong only in taxable accounts.
Stocks, in contrast, are tax-efficient for two reasons. First, they often produce more gains through capital appreciation than via dividends over the long term. If you hold onto them for at least a year, you’ll get the lower long-term capital gains rate when you sell them. Additionally, qualified dividends are taxed at a lower federal rate — in 2017, anywhere from 0 to 23.8%.
Today, those in the 15% tax bracket, for example, pay 15% federal income tax on bond and bank interest but absolutely nothing on qualified stock dividends. The bills in Congress wouldn’t end the tax break for qualified dividends.
Equities should yield larger capital gains than bonds in the long run, but you ultimately don’t get the lower capital gains rate in tax-deferred accounts. All withdrawals from such accounts are subject to ordinary income tax. This is another reason to place some stock funds in taxable accounts.
Be smart about which stock funds go into which accounts. Most international stocks and funds withhold foreign taxes on dividends paid. They should be held in a taxable account so you can recoup the foreign taxes you paid by claiming a foreign tax credit on your return.
Index funds are highly tax-efficient and work well in taxable accounts because they pay small distributions and have low turnover.
Actively managed stock mutual funds with high turnover often pay big taxable distributions at the end of the year. They should be held in tax-deferred or tax-free accounts. If you own a fund with high turnover, place it in a tax-deferred or tax-free account if possible.
The tax-free Roth IRA is ideal for equities, and because Roth assets grow tax-free, you should place high-growth investments in a Roth IRA.
With most other retirement plans, you or your heirs will ultimately pay ordinary income taxes on every penny that’s in them. Withdrawals from a Roth IRA are tax-free, which makes it a good place for the most aggressive component of your portfolio.
Asset location is not a one-size-fits-all decision, and there are complex variables to consider when deciding how to accomplish it. Variables such as future tax rate assumptions, the types and sizes of accounts owned, availability of investments, state income taxes, and estate-planning needs all need to be considered.
It’s as much an art as it is a science, and sometimes you have to make compromises with what’s ideal versus what’s practical.
While asset location may not save you a large amount of taxes in any one year, it should produce small increases in your after-tax return every year. Over decades, these small amounts compound and can really add up. There’s no need to pay more federal and state income taxes than you have to.
Unique factors can really add to the complexity of the asset location decision. It’s often a good idea to consult a financial planner to make sure you’re doing it right.
I spend significant time implementing asset allocation and asset location strategies for my clients. When the new tax law passes, I’ll reexamine my clients’ asset location strategies to see if we need to make any changes.
Thomas Walsh, Certified Financial Planner (CFP©) is a client service and portfolio manager with Palisades Hudson Financial Group in Atlanta.
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