SUB - How Asset Location Can Help Minimize Taxes And Maximize Returns

2023-04-22 05:46:00 ET

Summary

• When investing for retirement, it’s critical to stay focused on what really matters - after-tax returns, or the profits left over after any tax payments.
• The higher your tax rate, the more you could lose if your assets are not held in the right accounts and it’s critical to understand which assets are best held in taxable vs. tax-exempt vs. tax-deferred accounts.
• Consider talking to your advisor or accountant about where to place certain investments in 401Ks, IRAs and other accounts to help limit your future tax burden.

By Daniel Prince, CFA

What Is 'Asset Location'?

"Location, location, location" is the most important thing in real estate, or so the saying goes. The same is arguably true in investing because where you keep assets can be as important as what you're investing in.

Based on the principle that what really matters are after-tax returns, most investors could benefit from following this basic breakdown of where to put certain types of assets:

• Taxable Accounts: Traditional brokerage accounts are funded with post-tax dollars and your investment earnings will be taxed both during the accumulation phase and upon withdrawal. Consider anchoring these accounts with core equity ETFs, which tend to be tax-efficient , and municipal bonds which are generally exempt from federal taxes. ¹
• Tax-Deferred Accounts: Use 401(k), traditional IRAs and similar accounts to hold less tax-efficient assets. Taxable bonds, especially high yield, are well suited for tax-deferred accounts because more of their return tends to come from recurring income than capital gains. Tax-deferred accounts are generally not taxed during the accumulation period; however, because they are funded with pre-tax dollars, you will ultimately pay tax upon withdrawal at your ordinary income tax rate. The good news is that rate is likely to be lower after you've retired, assuming your gross income - or all income before taxes and deductions - is less than it was during your working years.
• Tax-Exempt Accounts: Accounts such as a Roth IRA are funded with post-tax dollars and therefore do not pay taxes during accumulation nor upon withdrawal, if certain requirements are met. This could be the ideal place to hold assets that may be less tax efficient and that you expect will generate high returns, such as stocks and actively managed funds. (Read more about key differences between traditional and Roth 401(k) accounts .)

Start with the big picture to help minimize tax costs

As a general rule, the higher your tax rate, the more you could lose if your assets are not held in the right accounts. It's also important to remember not all assets are treated equally for the purposes of taxation. When building a portfolio, investors may be able to keep more of what they earn by considering the different tax rates on investment income and holding less tax-efficient assets in tax-advantaged accounts like an IRA or 401(k).

Take bonds, for example. Treasury yields are near multi-decade highs and that's great for investors seeking income. In addition to providing a good yield, high quality bonds can also help investors reduce risk by diversifying a portfolio.

But income from bonds can be taxed at different rates than other investments. Interest from most bonds is taxed as ordinary income which can have a rate as high as 40.8%, while the highest rate applied to qualified dividend income from stocks is 23.8%. 2-year U.S. Treasury bonds were recently yielding around 4% which represents a higher yield than other short-term vehicles , like CDs and money market funds, while carrying less risk than equities. ² Investors can keep more of that potential income if the bonds are kept in a tax-advantaged account, as shown in the table below.

Asset location helps reduce taxation

For Illustrative Purposes Only. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Conclusion

Taxation hurts twice: When you pay, of course, and then over time as you're left with fewer dollars to benefit from compounding growth. Paying higher taxes today means less money remains invested for the future, and less opportunity for growth.

Whether you're already filed taxes for 2022 or have been granted an extension, consider talking to your advisor or accountant about where to place certain investments to help limit your future tax burden.

While individual circumstances can vary, the higher your tax rate, the more you could lose if your assets are not held in the right accounts. 'Location, Location, Location' is not just for real estate.

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¹ Source: Morningstar, as of 12/31/22. ETFs represent 26% of U.S. managed fund assets but accounted for less than 1% of capital gains distributions in 2021.

² Source: U.S. Department of the Treasury and Bankrate.com. The average 1-year and 5-year CD yield was 1.6% and 1.2%, respectively, according to Bankrate.com as of 3/29/2023.

³ Source: BlackRock as of 3/29/2023. US stocks represented by the trailing 12-month dividend yield of the S&P 500. Short-term Muni Bonds represented by the iShares Short-Term National Muni Bond ETF (SUB). After-tax yield is the pre-tax yield multiplied by (1 - tax rate). Assumes maximum tax rate of 40.8% for bonds and 23.8% for stocks, based on long-term capital gains rate which is applied to qualified dividend income (QDI).

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Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the value of debt securities. Credit risk refers to the possibility that the debt issuer will not be able to make principal and interest payments.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax ((AMT)). Capital gains distributions, if any, are taxable.

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This post originally appeared on the iShares Market Insights.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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