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Advisor Perspective

Advisor Perspective

Asset Location: Maximizing the After-Tax Return of Your Portfolio

Kirk Hackbarth

Advisor, CPA/PFS, CFP®
Kirk’s response times underscore his passion for helping clients build and implement their financial plans. He enjoys helping clients reach their goals and watching their plans come to fruition, particularly when it comes to tax strategies.

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Many investors don’t consider taxes when they are constructing their portfolios, but they can be one of the biggest drags on investment returns.

Asset location focuses on how investors allocate their investments across various account types. By actively monitoring your investment portfolio, assets can be placed in the optimal location. Tax-smart asset location can help improve the after-tax return of your portfolio.

Key Takeaways

  • Asset location can help lower your overall tax liability.
  • Know the differences between taxable, tax-deferred, and tax-exempt accounts.
  • Holding tax-inefficient investments in tax-deferred or tax-exempt accounts can improve the tax efficiency of your portfolio.

Asset Location Overview

Where you hold your investments, meaning the type of accounts you choose, can make a big difference in how much you earn, after taxes. That’s because different investments are subject to different tax rules, and different account types have different tax treatment. Investors can’t control the market or the tax laws but can control how to use different accounts that offer tax advantages to maximize after-tax returns. Always remember, it’s not what you earn, but what you get to keep after taxes, that really matters.

Investors have several different types of accounts that are used to accomplish various goals. Some are subject to taxes every year, while others have tax advantages. Here are the three main investment account categories:

  • Taxable accounts – brokerage accounts, savings accounts
  • Tax-deferred accounts – IRAs, SIMPLE-IRAs, 401(k)s, 403(b)s
  • Tax-exempt accounts – Roth IRAs, Roth 401(k)s, Roth 403(b)s

In its simplest form, asset location would place bonds in tax-deferred accounts and stocks in taxable accounts. That’s because earnings from bond investments are mostly interest and taxed at ordinary income tax rates. However, most of the income from stock investments is taxed at more favorable dividend and capital gains rates. Therefore, it is preferable to hold bonds (except tax-free municipal bonds) in a tax-deferred account and tax-efficient equities in taxable accounts. Investments with high appreciation potential should be placed in Roth accounts. Growth in the Roth accounts is permanently sheltered from ordinary income and capital gains taxes. Therefore, the goal is to hold investments that will maximize long-term growth.

Investors in high marginal income tax brackets should hold municipal bonds in taxable brokerage accounts. The interest is federally tax-exempt, and tax-exempt in some states.

Asset location takes advantage of these basic principles:

Not all account types are taxed the same way

Traditional IRAs are tax-deferred until you withdraw assets and then taxed as ordinary income. For 2024, the top federal marginal income tax rate is 37% (state taxes may also apply). Roth IRAs are tax-free—the growth is never taxed (assuming you meet the requirements). Finally, earnings in taxable accounts (whether interest, dividends, or realized capital gains) are taxed as they’re earned, not upon withdrawal.

Not all investment income is taxed the same way

Interest and some dividends are taxed at your ordinary income tax rate. Long-term capital gains and qualified dividends are taxed at a lower rate, 15% for many investors and up to 20% for the highest-income investors. Plus, you may owe an additional 3.8% tax called the net investment income tax (NIIT). But you’ll only owe it on investment income if your modified adjusted gross income is over $200,000 as a single tax filer and over $250,000 if married filing jointly.

How to incorporate an asset location strategy

Most investors understand the basic premise of asset allocation, spreading investments out among various asset classes, including stocks, bonds and cash. However, it’s also worthwhile to review your current investment holdings by account type. More specifically, review your accounts from a tax-advantaged perspective.

In general, the following investments tend to be more tax-efficient and should be held in your taxable accounts:

  • Individual stocks
  • Equity index mutual funds and ETFs
  • Tax-managed equity funds
  • Municipal bond investments

Investments that are tax-inefficient (generating primarily ordinary income) should be held in tax-deferred accounts like IRAs or 401(k)s:

  • Bonds and bond mutual funds (except municipal bonds).
  • Actively managed stock funds that have high turnover and can generate less favorable short-term capital gains.

Investments that are growth oriented should be held in tax-exempt accounts like Roth IRAs or Roth 401(k)s:

  • International equity investments, with a growth tilt
  • Domestic growth equity investments

Our team at JMG focuses on determining the proper account in which to place investments for the most favorable overall tax treatment. The best location for a particular security depends on an investor’s financial profile, prevailing tax laws, the client’s tax bracket, investment holding periods, and the tax and return characteristics of the underlying securities. Asset location is just one small part of our clients’ overall financial plan. However, it can have a big impact on after-tax portfolio returns. Please contact your JMG advisor with any questions that you might have. We invite you to share this article with others who may also find it helpful.

Important Disclosure

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by JMG Financial Group Ltd. (“JMG”), or any non-investment related content, made reference to directly or indirectly in this writing will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this writing serves as the receipt of, or as a substitute for, personalized investment advice from JMG. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. JMG is neither a law firm, nor a certified public accounting firm, and no portion of the content provided in this writing should be construed as legal or accounting advice. A copy of JMG’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a JMG client, please remember to contact JMG, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. JMG shall continue to rely on the accuracy of information that you have provided.

To the extent provided in this writing, historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices. Indices are not available for direct investment.