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A lack of attention to taxes may be costing investors big bucks.
Many investors are probably familiar with the concept of asset allocation, which entails selecting the right mix of stocks and bonds (say, 60/40) to balance investment risk and return.
But where those assets are held — i.e., the types of accounts in which stocks and bonds are located — is perhaps just as important, especially for wealthier investors, according to financial advisors.
This “asset location” strategy aims to minimize taxes, thereby boosting investors’ after-tax returns.
“Wealthier people should be as focused on tax allocation as they are on asset allocation,” said Ted Jenkin, a certified financial planner based in Atlanta and a member of CNBC’s Advisor Council. “And they’re not.”
Asset location “really starts to make sense” once investors’ income is high enough to put them in the 24% federal marginal income tax bracket, said Jenkin, founder of oXYGen Financial.
In 2024, the 24% bracket starts at roughly $100,000 of taxable income for single people and about $201,000 for married couples filing a joint tax return.
Why asset location works
Asset location leverages two basic principles, according to Connor McGuire, a CFP at Vanguard Personal Advisor.
For one, not all investment accounts are taxed the same way.
There are three main account types:
- Tax-deferred. These include traditional (i.e., pre-tax) individual retirement accounts and 401(k) plans. Investors defer tax on contributions but pay later upon withdrawal.
- Tax-exempt. These include Roth IRAs and 401(k) plans. Investors pay tax up front, but not later upon withdrawal.
- Taxable. These include traditional brokerage accounts. Investors pay tax when earning dividends or interest, or upon sale if there’s a profit.
Additionally, investment income is taxed differently depending on the asset type, McGuire said.
For example, interest income is taxed at an investor’s ordinary income tax rates. The highest earners might pay 37% or more on such interest.
But profits on investments like stocks held for more than one year are generally taxed at a lower federal rate. These long-term capital gains tax rates are 15% for many investors and 20% for the highest earners (plus any surcharges), McGuire said.
It can save you lots of money
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At a high level, asset location entails holding high-tax or tax-inefficient investments in tax-preferred retirement accounts like 401(k) plans and IRAs.
Conversely, investors would generally place investments with more-favorable tax rates and efficiencies in taxable accounts.
“It’s important because you want to reduce your tax drag,” said Robert Keebler, a certified public accountant based in Green Bay, Wisconsin, and partner at Keebler & Associates.
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Employing such a strategy can boost after-tax returns by 0.05% to 0.3% a year, depending on the investor, according to a 2022 Vanguard analysis.
According to this math, an investor with a $1 million portfolio split equally between stocks and bonds and spread across all three account types (traditional, Roth and taxable) could save $74,000 after 30 years by using asset location, McGuire said.
How to do it
Investors should use asset location within the framework of their appropriate asset allocation, such as a 60/40 stock-bond mix, advisors explain.
Many bonds and bond funds are generally more appropriate for tax-deferred or tax-exempt accounts, they said.
“Earnings from bond investments are mostly interest and taxed at ordinary income tax rates, meaning a hit of up to 37% plus any surcharges for high-income investors,” McGuire said. “So you want those bonds to be sheltered.”
Certain stock investments, like stock funds that are “super-actively managed” and generate ample short-term capital gains, also generally belong in tax-preferred accounts, Keebler said.
(Short-term capital gains are taxes on investments held for one year or less. They’re taxed as ordinary income instead of the preferential long-term rates.)
High-growth investments likely belong in a Roth instead of pre-tax retirement account, since investors wouldn’t pay tax on earnings later, Keebler said. (This assumes investors follow the appropriate Roth withdrawal rules.)
Wealthier people should be as focused on tax allocation as they are on asset allocation. And they’re not.
Ted Jenkin
CFP and founder of oXYGen Financial
Individual stocks that investors buy and hold for long-term growth, and stock funds with less frequent internal trading (generally, index funds instead of actively managed ones), are generally better-suited for taxable accounts, advisors said.
Municipal bonds are also generally more appropriate in taxable accounts, advisors said. That’s because their interest is exempt from federal tax.
Additional things to consider
Investors must weigh the particularities of each account type. For example, it may be tougher to access funds from a retirement account before age 59½ relative to a taxable account.
The benefits of diversifying across different account types go beyond investing, too.
For example, withdrawals from pre-tax 401(k) plans and IRAs generally count as taxable income and could therefore trigger higher Medicare Part B and Part D premiums. Withdrawing instead from a Roth account could help prevent those higher premiums, since distributions in retirement generally don’t count as taxable income.
Additionally, it’s impossible to know what tax rates and account taxation will be like decades from now, Jenkin said.
Having money in various accounts will provide tax flexibility n the future, he added.
