Mastering Asset Location Strategies for a Tax-Efficient PortfolioWe recently published an article on asset location that primarily covered the importance of strategically selecting which investing accounts to use and prioritize based on your financial goals, needs, and current and projected income. However, if you have decided to use multiple types of investing accounts because you have a high income, a high savings rate, or both, there is another important aspect of asset location you must consider: which assets or asset classes should be held in which account? Investors with large, diversified portfolios tend to invest across a range of asset classes (e.g., equities, fixed income, cash equivalents) and invest diversely within each asset class as well. For example, within the class of equities, an investor might invest in US large-cap stocks, US small-cap stocks, emerging markets stocks, and international developed stocks. After you have determined which accounts you will use and your preferred asset allocation or which types of asset classes you will invest in and how much of your portfolio each asset class will make up, you need to determine how those assets will be distributed across your accounts. How each asset is taxed informs where it should be located, allowing you to optimize your investing strategy by reducing your tax burden.
Assets Best Suited for Tax-Deferred Accounts
In most cases it is prudent to use a tax-deferred account, such as a traditional IRA or traditional 401(k), for long-term investments that pay high dividends or generate taxable income that will be regularly reinvested in the account. Income-generating assets include taxable bonds and high-dividend stocks or mutual funds. It is best to invest these types of assets in a tax-deferred account so you do not receive an IRS 1099 tax form at the end of each year for income that you already reinvested. It can also be wise to use a tax-deferred account for actively managed funds and other tax-inefficient assets that frequently buy and sell investments, which would otherwise trigger short-term capital gains taxes for each transaction. Keeping these types of assets in a tax-deferred account shelters them from these tax implications until you decide to withdraw your money. These strategies can keep your annual tax returns simpler and help reduce the overall amount you pay in taxes over your life.
Assets Best Suited for Roth IRA Accounts
It is often preferable to hold asset classes with the highest appreciation potential, such as US large-cap growth stocks with significant long-term appreciation prospects, in a Roth IRA account so you can enjoy the full benefits of their growth without paying income taxes on the appreciated amount. Additionally, the assets you plan to hold for the longest period are often well suited to a Roth IRA account. The longer your time horizon is, the more time your investments have to increase in value, enabling you to make the most of the tax-free qualified withdrawals a Roth IRA account allows.
Assets Best Suited for Taxable Accounts
Taxable brokerage accounts do not offer the same benefits as their tax-advantaged counterparts, but they are still invaluable tools for growing your wealth and generating passive income through investing. If you are already investing to the maximum limit in your Roth IRA account or prefer not to use such an account, investments with high appreciation potential can also be suitable for a taxable account. There they will be subject to capital gains taxes but will avoid the ordinary income tax rates they would eventually face if you kept them in a tax-deferred account. Tax-efficient assets, such as passive, low-turnover index funds and tax-exempt bonds, are ideal for taxable brokerage accounts. These investments trigger fewer taxable events, minimizing their impact on your annual tax return. Taxable accounts are also well suited for assets with tax-loss harvesting potential, meaning those that you can easily sell and replace with a similar asset when returns are down so you can count the loss against your income without significantly changing your asset allocation.
Many high-income professionals want to invest for retirement and create generational wealth, but the complexity of creating and enacting an effective and tax-efficient long-term investing strategy can intimidate them Conversely, the detailed work of optimizing their portfolios and enjoying learning new ways to improve their approach to investing excites some high-net-worth investors. Both types of people often find value in consulting a financial professional who specializes in working with high-net-worth and high-income individuals and can help them identify and implement the asset location strategies that will work best for their situation.