How to Use Asset Location to Help Maximize After-Tax Returns

There is an old adage that says it’s not what you earn but what you save that ultimately matters. In investing overall returns are very important of course, but how much of that you get to keep after tax is as important. Asset location is a crucial aspect of wealth management that can significantly impact the after-tax returns on your investments. It involves strategically placing different types of investments in specific accounts to help minimize taxes and maximize growth.

What is Asset Location?

In the world of investing, there are two key components to consider: asset allocation and asset location. While asset allocation refers to the distribution of your investments across various asset classes (like stocks, bonds, and real estate), asset location focuses on placing these assets in the right types of accounts to help optimize tax efficiency.

The three main types of accounts to consider for asset location are:

1. Taxable Accounts: These accounts include brokerage accounts where any income (like dividends or interest) and realized capital gains are subject to taxes each year.
2. Tax-Deferred Accounts: Examples include traditional Individual Retirement Accounts (IRAs) and 401(k) plans. Here, investments grow tax-deferred, meaning you don’t pay taxes until you withdraw the money, usually during retirement.
3. Tax-Free Accounts: Roth IRAs and Roth 401(k)s fall into this category, along with Health Savings Accounts that are invested.   Investments grow tax-free, and qualified withdrawals during retirement are also tax-free.

Why is Asset Location Important?

The primary goal of asset location is to reduce the impact of taxes on your investment returns. Different types of investments generate different kinds of income, which can be taxed at varying rates. By strategically placing these investments in the appropriate accounts, you can take advantage of tax deferral or tax exemption opportunities, ultimately aiming to enhance your overall after-tax returns.

General Guidelines for Asset Location

1. High Tax Efficiency Assets in Taxable Accounts:
   • Stocks: Long-term capital gains from stocks are typically taxed at a lower rate than ordinary income. Additionally, qualified dividends from certain stocks may also be taxed at a reduced rate.
   • Municipal Bonds: Interest from municipal bonds is often exempt from federal (and sometimes state) taxes.
   • Index Funds and ETFs: These investment vehicles generally have lower turnover rates, leading to fewer taxable events.
2. Tax-Deferred Accounts for Income-Generating Assets:
   • Bonds: Interest income from bonds is taxed as ordinary income, which can be higher than long-term capital gains rates. Placing bonds in tax-deferred accounts can defer these taxes.
   • REITs (Real Estate Investment Trusts): REIT dividends are typically taxed as ordinary income, making them suitable for tax-deferred accounts.
3. Tax-Free Accounts for Growth-Oriented Assets:
   • Stocks with High Growth Potential: Placing high-growth stocks in a Roth IRA or Roth 401(k) can allow for tax-free growth and withdrawals.
   • Convertible Bonds: These bonds can be converted into stocks, potentially leading to significant growth that can be tax-free in a Roth account.

Here’s a chart summarizing the asset location strategy:

Examples of Asset Location

To illustrate the concept of asset location, let’s consider a hypothetical investor named Alex, who has a diversified portfolio consisting of stocks, bonds, and REITs.

1. Stocks in Taxable Accounts:
   • Alex holds a mix of large-cap and dividend-paying stocks in a brokerage account. The long-term capital gains and qualified dividends from these stocks are taxed at favorable rates.
2. Bonds in Tax-Deferred Accounts:
   • Alex allocates corporate bonds and Treasury bonds in a traditional IRA. The interest income is tax-deferred until withdrawal during retirement, when Alex may be in a lower tax bracket.
3. REITs in Tax-Deferred Accounts:
   • Alex holds REITs in a 401(k) plan. The ordinary income generated by the REITs is tax-deferred, allowing for potential growth without immediate tax implications.
4. Growth Stocks in Tax-Free Accounts:
   • Alex places high-growth stocks in a Roth IRA. The significant appreciation potential of these stocks can be realized tax-free during retirement.

Asset location is an essential strategy for investors as it helps to optimize after-tax. By understanding the tax characteristics of different investments and strategically placing them in the appropriate accounts, you can enhance the growth of your portfolio while minimizing what Uncle Sam gets from you.  In general, this is a pretty complex strategy to implement as most families have multiple accounts within each category and keeping it in balance is equally dauting.  Your Bluerock Team has been using this strategy to help you keep more of what you earn.  Reach out to your Wealth Manager if you have more questions!

Raj Chokshi, Partner and Wealth Manager