Finding the Sweet Spot with Tax Location

Some parts of this blog were updated on March 14, 2018

If you have multiple investments, do you consider the most appropriate account for each of your assets? If not, you should. Each of your accounts has unique tax characteristics, and if you understand these characteristics, you can place your assets in the most advantageous accounts, thereby minimizing your tax liabilities.

This concept is called tax location. The benefits of tax location have been well-catalogued, with studies pointing to a boost of 20-plus basis points per year on average. This means more money in your pockets without any change to your asset mix; it all comes from simply paying attention to which account you use for each asset.

Account Types

There are essentially three main types of investment accounts:

• Taxable: Gains are taxed in the year they were earned, e.g. individual, joint, custodial, and trusts
• Tax-deferred: Pre-tax money is contributed to these accounts, with taxes due on principal or earnings when they are withdrawn, e.g. 401k, IRAs (SEP, Simple, Traditional)
• Tax-exempt: After-tax money is contributed to these accounts. Earnings and dividends accrue tax free (subject to early withdrawal restrictions), e.g. Roth IRA/401k, HSA (when used for health expenses), and 529 plans

Since each of these accounts is treated very differently from a tax perspective, it makes sense to consider the tax sensitivity of each asset before you assign it to your accounts.

Asset Types

There are two key facts that generally determine the tax burden associated with an asset. The first is the nature of the asset’s gains – are they classified as capital gains, dividends or income? The second factor is the size of the returns. Here are some asset-type examples:

• Equities: Gains in stocks held one year or longer are taxed at a preferential long-term rate. Short-term gains and non-qualified equity dividends are taxed as ordinary income. Long-term holdings are tax efficient, but short-term holdings are tax inefficient.
• Bonds: Taxes on bond capital gains are the same as for equities, but interest payments are taxed as ordinary income. The actual tax paid depends on the type of bond. Bonds can be either tax inefficient or tax efficient depending on the type of bond.
• REITs: The IRS requires REITs to pay out at least 90% of their income to shareholders every year to avoid taxation at the corporate level. For the most part, these payouts are taxed as ordinary income. REITs are tax inefficient.
• Commodities: Commodity funds fall into two basic categories: 1. Those that hold physical assets like precious metals, and 2. Those that own futures contracts to track commodity prices. Precious metal investments are considered “collectables” and are taxed at a higher capital gains rate. Funds that hold futures are usually structured as limited partnerships and taxed at a combination of long- and short-term rates. They also are taxed on unrealized gains annually. Many commodity funds are tax inefficient.

General Allocation Rules

So how do you allocate these very different assets?

Optimizing around long-term growth rates and tax rates can get very complicated. But to save money immediately, there are two general rules:

• 1. Assets with high expected income and inefficient taxing should be assigned to tax-deferred or tax-exempt accounts.
  2. Assets with low expected income and efficient taxing should be assigned to a taxable account.

At Personal Capital, our financial advisors automatically direct client purchases of high-yielding tax-inefficient assets, such as REITs and high yield bonds, to available IRA accounts. More tax-efficient assets, such as equities, are assigned to a taxable brokerage account. This combination of sheltered earnings and tax-efficient growth may result in a smaller tax bill and more money available for your retirement.

Assigning different types of assets to different investment accounts for tax optimization can be complicated. Learn more by reading our free Personal Capital Tax Guide for the Savvy Investor.

Download guide

This blog is for informational purposes only and is intended to offer guidance; not specific legal or tax advice. Clients are advised to consult their personal estate attorney and CPA before taking action based on this advice.