Investors are typically familiar with the concept of asset allocation, which involves determining the right mix of stocks and bonds to balance risk and return. However, the location of these assets within different types of accounts can have a significant impact on investor taxes. According to financial advisors, asset location is just as crucial, especially for wealthier investors who are looking to maximize after-tax returns. This strategy aims to minimize taxes and boost the overall performance of an investment portfolio.
Asset location is based on two fundamental principles, as outlined by Connor McGuire, a Certified Financial Planner at Vanguard Personal Advisor. The first principle involves understanding that not all investment accounts are taxed in the same manner. There are three main types of accounts: tax-deferred accounts (such as traditional IRAs and 401(k) plans), tax-exempt accounts (including Roth IRAs and 401(k) plans), and taxable accounts (such as traditional brokerage accounts). Each of these accounts has its unique tax implications that investors must consider.
Investment income is taxed differently based on the asset type. For instance, interest income is typically taxed at ordinary income tax rates, which can be as high as 37% for top earners. On the other hand, profits from investments like stocks held for over a year are subject to lower federal tax rates, ranging from 15% to 20%. By strategically positioning high-tax investments in tax-preferred retirement accounts and tax-efficient investments in taxable accounts, investors can reduce their tax burdens and enhance their after-tax returns.
Employing an asset location strategy can potentially boost after-tax returns by 0.05% to 0.3% annually, according to a Vanguard analysis. For instance, an investor with a $1 million portfolio split between stocks and bonds across different account types could save $74,000 over 30 years by utilizing asset location effectively. Advisors recommend integrating asset location within the broader context of an investor’s asset allocation, ensuring that the right investments are held in the most tax-efficient accounts.
Certain investments are better suited for specific account types based on their tax characteristics. For example, bonds and bond funds are typically more appropriate for tax-deferred or tax-exempt accounts due to their interest income being taxed at ordinary rates. Similarly, high-growth investments and stocks with significant short-term gains should be held in tax-preferred accounts to minimize tax implications. Investors must carefully assess the tax implications of each investment and account type to maximize their after-tax returns.
Wealthier investors are encouraged to focus on tax allocation just as diligently as asset allocation. By strategically locating assets based on tax efficiency, investors can potentially save significant amounts on taxes over the long term. Additionally, diversifying assets across different account types provides tax flexibility and helps mitigate potential tax increases in the future. While it’s impossible to predict future tax rates, having a well-diversified portfolio across various account types can offer financial benefits and peace of mind for investors.