Recent tax increases have made the overall tax bite more painful for many clients, with rates higher on ordinary income, long-term capital gains and qualified dividends, not to mention the Medicare surtax. Because the tax calculus for various types of investment income has also changed, planners should pay renewed attention to asset location - whether to place particular investments in taxable or tax-deferred accounts.
By putting an asset into the type of account that will give it the best tax treatment, planners say, clients might be able to realize 20 to 50 basis points of additional return each year. That may not sound like much, but after 30-plus years, the tax savings can add up. In fact, Morningstar considers asset location a key element of its new "gamma" factor - a way to calculate an advisor's value that Morningstar argues can, in total, boost final retirement income by 29%.
"What we don't want people to do is have the same asset allocation in all their different types of accounts," says David Blanchett, head of retirement research at Morningstar Investment Management.
For asset location strategies to work, a client needs a sizable pool of taxable assets - otherwise, tax considerations will take a backseat to other concerns.
In addition, a client's tax bracket will determine how aggressively to pursue asset location. "If your marginal tax rate is 15% and your qualified dividends are at 15%, then the benefits of asset location decrease significantly," Blanchett says.
INEFFICIENT, BUT PROFITABLE
While different advisors practice asset location in different ways, there are a few guidelines. "You start with the most tax-advantageous accounts and you start filling them with the most tax-inefficient investments," says Jean-Luc Bourdon, a principal with BrightPath Wealth Planning in Santa Barbara, Calif. "Real estate investment trusts are particularly tax-inefficient, as are commodity futures."
Within tax-deferred accounts, the best fit are investments that generate income subject to the ordinary tax rate, which can be as high as 39.6%. Fran Kinniry, a principal with Vanguard's Investment Strategy Group, argues that tax-deferred accounts are "extremely valuable shelf space," and should be populated first by taxable bonds. "Only if you still had tax-qualified shelf space, then you could use it for hedge funds or high turnover active funds," he adds.
Taxable accounts, on the other hand, should hold growth stocks and dividend-paying stocks, many advisors say, because the capital gains and dividend tax rates applied to them won't exceed 20% for most investors. There's no point in housing investments that could be subject to this lower rate in a deferred account, only to pay the much-higher ordinary tax rate at the time of withdrawal, advisors say. Similarly, tax-exempt muni bonds are best suited for taxable accounts.
Some advisors offer a caveat to that rule, however, suggesting that clients have a small portion of other asset classes in each account type - just to prevent having to sell in a downturn if there's a need to raise cash. "You just never know what life throws at you," says Ed Slott, a CPA (and Financial Planning contributing writer) in Rockville Centre, N.Y.
Roth accounts, both in IRA and 401(k) form, are good places for small-cap stock funds, which can have high turnover rates, potentially generating considerable taxable income.
EXCEPTIONS TO THE RULES
The guidelines are not ironclad. Asset location strategies must also jibe with individual investing behavior, Slott says. While he usually urges clients to put taxable bonds in tax-deferred accounts, for instance, there are exceptions: "If you're a big trader, then you're better off having your equities in a tax-deferred IRA."
He offers a couple of reasons. First, the short-term capital gains generated by frequent trading can be a nightmare in a taxable account. Rapid traders also incur high tax-preparation costs, he notes. Better to trade equities in an account where no tax reporting is required.
Real estate is another gray area in Slott's view. It has traditionally been put into tax-deferred accounts because earnings from real estate investments, whether through equities like REITs or direct holdings, are taxed as ordinary income. By doing so, however, clients lose out on the ability to take depreciation on directly held real estate.
Slott is most emphatic about not placing highly appreciating assets in a tax-deferred account, because "eventually you have to pay the piper," he says. Those belong in a Roth, he adds.
Some advisors also use the asset locations within a client's account to help determine investment strategies. "There are certain strategies we rule out if we cannot shelter them," says Jared Kizer, director of investment strategy with St. Louis-based Buckingham Asset Management. "If all the investments we're managing for a client are in taxable accounts, then we cannot use REITs."
Decisions about asset location can also be critical during a client's withdrawal phase. Most advisors agree that, before clients reach age 701/2, when they must make mandatory withdrawals from tax-deferred accounts, they should first draw down from their taxable accounts - allowing the tax-deferred pot to continue to grow as long as possible.
When the taxable account is depleted, then the tax-deferred account can be tapped, ending with the Roth. "Since the Roth IRA doesn't require minimum distributions, it can be a good tool for estate planning," Bourdon says. "Roth conversions offer an opportunity for more IRA assets to continue to grow tax-free, and therefore can allow more wealth to accumulate for heirs."
But repeatedly withdrawing from one account type (and, possibly, one asset class) could mean a lopsided asset allocation. Instead, Kizer advises the following strategy: Sell stocks out of the taxable account and then sell the same dollar amount of bonds in the tax-deferred account to buy back the stocks that were sold. "On net, you ended up selling fixed income," he says. (Note: Be certain to avoid a wash sale.)
PREFERENTIAL TREATMENT
One widely followed advisor, Michael Kitces, a partner and research director at Pinnacle Advisory Group in Columbia, Md., offers another factor to consider: expected investment returns. To put bonds in tax-preferred accounts and stocks in taxable ones in the current low interest rate environment doesn't make much sense, he contends, if the investment nets very little. "There is no economic value of getting tax deferral on something that doesn't generate much actual return," he says.
Further, Kitces argues, even buy-and-hold investors experience some turnover through periodic rebalancing and dividend payments. By receiving preferential tax treatment for decades, investors would end up with more money by holding equities in IRAs or 401(k)s. Those assets' potential for greater appreciation will most likely result in a bigger pool of money over time, so shielding that money from taxes is critical, he says. "Focus on the investments that really matter," he says about the higher anticipated returns of stocks, "and you let the bonds land where they may."
Perhaps not surprisingly, some experts say that strategy is badly flawed. "The investment return just amplifies the benefit of tax deferral," Bourdon argues. "The expected return doesn't change the decisions."
What's more, by holding equities in a tax-sheltered account, there is no possibility of tax-loss harvesting to offset gains elsewhere. Says Kinniry: "This environment of low returns and higher taxes makes it that much more important to do it correctly."
Ilana Polyak, a Financial Planning contributing writer in Northampton, Mass., has also written for The New York Times, Money and Kiplinger's.
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