Tax-Wise Investing with Asset Location

by Jeff C. Johnson

Piggy banks

Determining how much money you invest in stocks, bonds, and cash, as presented in my previous post, is an important early step in implementing your financial plan. It’s called your “asset allocation” and is based on your ability, need, and willingness to take financial risks.

As your portfolio grows, and your income tax bill increases, it will become more and more important for you to take a tax-wise approach.

Buckingham Strategic Wealth, founded by practicing CPAs, took a very proactive attitude to proper “asset location” to take full advantage of obtaining the lowest possible income tax impact.

Under present law, the federal tax rate on dividends and long-term capital gains is 15 percent (or 20 percent under certain circumstances), while the maximum income tax on earnings and interest is 39.6 percent. These percentages do not reflect state income taxes.

Consider that by holding equity investments in a tax-deferred retirement account (such as an IRA), you could be effectively converting lower-taxed investment returns into fully taxable future income. Dividends paid on stocks and stock mutual fund shares, as well as capital gains incurred, are deferred in an IRA, of course, but when taken out as a distribution, the income is fully taxable.

A proactive asset location strategy would hold tax-inefficient investments, such as taxable bonds, bond mutual funds, and some growth investments, in an IRA or 401(k). The income is sheltered from immediate taxation, then paid in the future and taxed as it would have been if the assets had been held in a taxable account.

Placing equity investments such as stocks and stock mutual funds in a personal taxable account offers several advantages over holding these assets in a tax-deferred account. First, investments incur the lower tax rate of 15 or 20 percent (so, to be clear, half or less of the top tax rates), not the fully taxable income rate of an IRA or 401(k) withdrawal.

Next, long-term capital gains are generally not taxed until positions are sold, so there is some element of deferral (the delay of taxes into the future when a stock or fund is sold). Plus, losing positions can be sold for a tax-deductible loss, unlike in a tax-deferred retirement account.

Lastly, based on current law, unrealized, untaxed gains in a portfolio at death are “stepped up” to the present value, eliminating the capital gain altogether.

The asset allocation and asset location decisions are important to long-term results and should be considered carefully and reviewed regularly with a knowledgeable professional.