When it comes to investing, many people focus on asset allocation in terms of selecting the right mix of stocks and bonds. However, what often gets overlooked is the importance of asset location. Asset location refers to where your investments are held, such as in tax-deferred accounts like traditional IRAs or taxable accounts like brokerage accounts. This strategy is crucial for maximizing after-tax returns, especially for wealthier investors who may be in higher tax brackets. According to financial advisors like Ted Jenkin, tax allocation should be a priority along with asset allocation.
Understanding Tax Efficiency
Not all investment accounts are taxed the same way. There are three main types of accounts: tax-deferred, tax-exempt, and taxable. Each has its own tax implications that can impact your overall investment returns. For example, interest income is taxed at ordinary income tax rates, while long-term capital gains from investments like stocks are taxed at a lower federal rate. By strategically placing high-tax or tax-inefficient investments in tax-preferred accounts and vice versa, investors can reduce their tax burden and increase their after-tax returns.
Employing asset location strategies within the framework of your appropriate asset allocation can lead to significant savings over time. For instance, an investor with a $1 million portfolio evenly split between stocks and bonds across different account types could potentially save $74,000 over 30 years by optimizing asset location. Bonds and bond funds are typically better suited for tax-deferred or tax-exempt accounts due to their interest income being taxed at ordinary income rates. On the other hand, high-growth investments and stock funds with less frequent trading are often more suitable for taxable accounts.
Wealthier investors, in particular, should pay close attention to tax allocation strategies. Placing certain investments in tax-preferred accounts like Roth IRAs can provide long-term tax benefits, especially for high-growth assets. By diversifying across different account types, investors can not only optimize their investment returns but also prepare for potential changes in tax rates and regulations in the future. Withdrawal strategies from different account types can also impact other aspects of financial planning, such as Medicare premiums and overall tax flexibility.
Asset location is a crucial yet often overlooked aspect of investing that can have a significant impact on after-tax returns. By strategically placing investments based on their tax efficiency and considering the long-term implications of different account types, investors can maximize their overall investment performance. Wealthier individuals, in particular, stand to benefit from implementing tax allocation strategies alongside their asset allocation decisions. Ultimately, a well-thought-out asset location strategy can lead to greater financial success and wealth preservation over time.