Many investors are well-versed in the concept of asset allocation, but what about asset location? Financial advisors suggest that where assets are held can have a significant impact on after-tax returns, especially for wealthier investors. Despite this, many individuals fail to give sufficient attention to the tax implications of their investment decisions.
Asset location involves leveraging the tax advantages of different types of investment accounts to minimize taxes and maximize returns. There are three main account types to consider: tax-deferred accounts, tax-exempt accounts, and taxable accounts. Each account type is taxed differently, with varying rates and implications for investment income.
Tax Efficiency and Investment Income
Investment income is subject to varying tax rates depending on the asset type. For example, interest income is taxed at ordinary income tax rates, which can be as high as 37% for top earners. On the other hand, long-term capital gains from investments like stocks are taxed at lower federal rates, ranging from 15% to 20%. Strategic asset location involves placing high-tax or tax-inefficient investments in tax-preferred retirement accounts and more tax-efficient investments in taxable accounts.
According to a Vanguard analysis, employing asset location strategies can boost after-tax returns by 0.05% to 0.3% annually for investors. This may not seem like a significant amount, but over time, it can lead to substantial savings. For example, a $1 million portfolio could potentially save $74,000 over 30 years by using asset location effectively.
Asset location should be used in conjunction with an appropriate asset allocation strategy, such as a 60/40 stock-bond mix. Bonds and bond funds, which generate interest income taxed at ordinary rates, are generally more suitable for tax-deferred or tax-exempt accounts. On the other hand, high-growth investments and stock funds with minimal internal trading are better suited for taxable accounts.
Considering the Future
Wealthy investors should focus on tax allocation as much as asset allocation to maximize their investment returns. By strategically placing investments in different account types, investors can not only minimize their tax liability but also plan for future tax flexibility. As tax rates and regulations can change over time, having a diversified portfolio across various account types can provide valuable options for the future.
Asset location is a crucial but often overlooked strategy for maximizing after-tax returns for wealthy investors. By carefully considering the tax implications of where investments are held, individuals can enhance their overall investment performance and create a more tax-efficient portfolio. It’s time for investors to shift their focus from just asset allocation to strategic asset location for long-term financial success.