Many investors are well-versed in the concept of asset allocation, which involves selecting the right mix of stocks and bonds to balance risk and return. However, equally important is where those assets are held, known as asset location. This strategy is particularly crucial for wealthier investors as it aims to minimize taxes, ultimately boosting after-tax returns.
Asset location becomes especially relevant for investors in the 24% federal marginal income tax bracket. This bracket starts at approximately $100,000 of taxable income for single individuals and $201,000 for married couples filing jointly. The key principles behind asset location involve understanding the different tax implications of various investment accounts.
Investment accounts fall into three main categories: tax-deferred, tax-exempt, and taxable. Tax-deferred accounts include traditional IRAs and 401(k) plans where taxes are deferred until withdrawal. Tax-exempt accounts like Roth IRAs involve paying taxes upfront. Taxable accounts such as traditional brokerage accounts require taxes to be paid on dividends, interest income, or profits upon sale.
Different types of investment income are taxed at varying rates. For example, interest income is taxed at ordinary income tax rates, which can be as high as 37% for top earners. On the other hand, long-term capital gains from investments like stocks held for over a year are taxed at lower federal rates ranging from 15% to 20%.
Asset location involves strategically placing high-tax or tax-inefficient investments in retirement accounts while keeping more tax-efficient investments in taxable accounts. By reducing tax drag, investors can potentially increase their after-tax returns by 0.05% to 0.3% annually. Employing this strategy within the context of an appropriate asset allocation can result in significant tax savings over time.
Certain investments, such as bonds, are better suited for tax-deferred or tax-exempt accounts due to their interest income being taxed at ordinary rates. Conversely, high-growth investments and actively managed stock funds generating short-term capital gains are more suitable for tax-preferred accounts. Roth accounts are ideal for investments with significant growth potential to avoid future tax implications.
Wealthier investors should prioritize tax allocation alongside asset allocation to maximize their investment returns. By diversifying across different account types, investors can gain tax flexibility in the future and mitigate potential tax risks. It is essential to assess the tax implications of each account type and strategically place investments to optimize tax efficiency.
Tax allocation is a critical aspect of investment planning, especially for high-income individuals. By understanding the nuances of asset location and strategically placing investments across various account types, investors can enhance their after-tax returns and build a more tax-efficient investment portfolio. It is imperative for wealthier investors to prioritize tax efficiency in their investment strategy to maximize long-term wealth accumulation.