Location, Location, Location!

Location, Location, Location!

Just as in real estate, location matters in managing investments.   Where you place different types of investment assets (such as stock and bonds) can have a significant impact on the after-tax return you realize over time.  Let’s work through an example and then examine the tax concepts that lead to the results and some general guidance for asset location.  Assume the following:

• Total Investment Portfolio $1,000,000 of which 50% is to be invested in stocks and 50% in bonds based on your risk tolerance and income needs.
• Your investment portfolio is also divided 50% into a regular investment account where taxes on realized investment income are paid annually and 50% into a regular IRA account where income is deferred until withdrawn.
• Stocks are expected to have a total return of 7.5% with 2% of that coming from qualified dividends and 5.5% coming from unrealized (deferred) capital gains.  Based on your tax bracket, qualified dividends and capital gains are taxed at 15%.  You do not plan on selling any of the stock fund until you begin to take distributions in retirement, so all gains are deferred for the next 20 years.
• Bonds are expected to have a 3.5% total return comprised of ordinary interest income.  Interest income is taxed at your marginal tax bracket of 32%.
• IRA distributions are taxed at your marginal tax bracket of 32%
• You are subject to the 3.8% surtax on all your investment income.
• You will hold the portfolio for 20 years then start taking distributions at the same tax brackets.
• Your overall expected annual return from the portfolio is 5.5% before taxes based on the holdings and rates above.

A naïve investor might assume it is best to place the stock portion of the portfolio in the IRA since they have a higher expected return, while placing bonds in the taxable account.  Doing so, however, would eventually cause qualified dividends and capital gains to be effectively tax at higher ordinary income tax rates when distribute.  In this scenario the overall portfolio would grow to $2,903,722.  Taxes would be due on distributions from the IRA.  This would result in $2,393,800 of net spendable proceeds during retirement.  This is an after-tax return of about 4.46% per year.  Compared to a pre-tax expected return of 5.5% there is a “tax drag” of 1.04% with an effective tax rate of 18.9%).

If, on the other hand, you consider the tax advantage of favorable rates on qualified dividends and the deferral of unrealized gains in the stock portfolio it is actually optimal to put all the stocks in the taxable account and the bonds in the IRA. In this scenario the overall portfolio would grow to $2,975,079.  Taxes would be due on distributions from the IRA and on realized gains as stocks are sold in the taxable account.  This would result in $2,521,465 of net spendable proceeds during retirement.  $127,485 more than the naïve scenario.   This is an after-tax return of about 4.73% year.  Compared to a pre-tax expected return of 5.5% there is a “tax drag” of 0.77% with an effective tax rate of 13.9%).  The new asset location results in 27 basis points (0.27%) of additional return each year during the 20-year period.

Tax Basics for Investing

The United States has a progressive tax system.  The higher your income the higher your tax rate on your income.  The table below shows the 2023 tax rate schedule for individuals using two filing statuses – single and married filing jointly – as examples:

Tax Rate	Single Filers – Level of Taxable Income	Married Filing Joint Returns
10%	First $11,000	First $22,000
12%	$11,000 to $44,725	$22,000 to $89,450
22%	$44,725 to $95,375	$89,450 to $190,750
24%	$95,375 to $182,100	$190,750 to $364,200
32%	$182,100 to $231,250	$364,200 to $462,500
35%	$231,250 to $578,125	$462,500 to $693,750
37%	$578,125 or more	$693,750 or more

Most income (called ordinary income) is taxed at the same rates. Investment income, however, is subject to some special tax rules, particularly the special treatment of qualified dividends and long-term capital gains. It is important to understand these rules to maximize after tax investment returns.  Internal Revenue Service Publication 550 is a great resource on the subject; however, I summarize the most important points here. 

Investment income includes interest, dividends, short term capital gains, long term capital gains and mutual fund distributions.  Other distributions may also be taxable depending on the nature of the entity and distribution.  Generally, all your investment income is included in your taxable income and taxed at your tax rates shown above.  There are a couple of notable exceptions. Interest on municipal bonds (state or local government bonds) is generally non-taxable. Some of these bonds, however, are taxable, such as federally guaranteed bonds or those related to a private activity may be subject to ordinary tax or alternative minimum tax. Qualified dividends and net long term capital gains are taxed at lower rates shown in the table below.  Qualified dividends are generally dividends from U.S. company stock investments held for 60 days (common stock) or 90 days (preferred stock). This includes stock dividends that flow through from an ETF or mutual fund.   Long term gains are gains on assets held more than one year. The rate depends on your filing status and level of taxable income.  Capital gains are the difference between the selling price of an investment and the cost of that investment (known as the tax basis).

Tax Rate	Single – Level of Taxable Income	Married Filing Joint Returns
0%	Up To $44,625	Up to $89,250
15%	$44,625 to  $492,300	$89,250  to $553,850
20%	Over $492,300	Over $553,850

Compared to the ordinary tax rates presented earlier, you can see that the tax rate on qualified dividends and long-term capital gains presents a significant savings. 

Optimal Asset Location

As noted above in the first example, different types of accounts have differing tax treatments.  A typical regular investment account is taxed annually, whereas retirement accounts are either tax deferred or tax exempt.  An employer retirement plan or traditional IRA is tax deferred until funds are withdrawn.  Roth type accounts are both tax deferred and withdrawals are not taxed in most cases.  Investment income in a regular account is taxed at either ordinary income tax rates (interest, and short-term gains) or a lower favorable rate (long term gains and qualified dividends). Distributions from traditional retirement accounts and IRAs are taxed as ordinary income even if they were generated by capital gains.  As a result, if multiple types of accounts are available you may not want to have the same allocation across accounts. Instead, you should determine each investment optimal location to maximize the after-tax return.  Here are some general guidelines:

• Very low yielding assets held for liquidity or diversification (for example money market accounts in normal market situations) should generally be in taxable accounts where they can be easily accessed. Municipal bonds and municipal money market funds are a special case.  They should always be in taxable accounts regardless of yield.  They should not be placed in tax deferred or tax-exempt accounts as doing so would convert tax free income to taxable ordinary income.
• Assets generating mainly ordinary income and short-term gains taxable as ordinary income should generally be in tax deferred or tax-exempt accounts.  For example, higher yielding bonds and real estate investment trusts.
• Assets generating mainly qualified dividends and long-term capital gains should generally be in taxable accounts depending upon the expected holding period (the longer the planned holding period the longer the tax deferral and more likely it should be in a taxable account).  For example, stocks investments rather held directly or indirectly through ETFs or mutual funds.

These general guidelines can also conflict with each other, and asset location can be an art.  For example, when bonds have very low expected returns and yields, the first guideline would suggest a taxable account is fine as they are lower return while the second would lean towards a deferred account.  In these circumstances, you should also consider liquidity needs and place in taxable accounts more assets that have lower volatility that could be sold when liquidity needs present themselves. 

Some accounts such as trusts may render these guidelines null and void as the trust instrument must be adhered to.  Circumstances, needs or preferences may also require non-optimal tax locations (for example, most of the portfolio in taxable accounts with very little in tax deferred accounts or vice versus, when the accounts are in different family member names, when accounts are designed to fund specific goals or have different beneficiaries). When it is not optimal to place assets in the preferred account type you can engage in tax loss harvesting or other strategies to manage tax costs.

Summary

In summary, where possible you should allocate investments to the accounts where you will maximize the after-tax returns.  Investment strategies for investment assets should also be placed appropriately.  For example, a popular strategy is a covered call strategy where you buy stocks but sell slightly out of the money calls.  This can be done directly with individual stocks or ETFs or through investing in a fund that uses a covered call strategy.  Overall, this tends to have a modest reduction in long term returns relative to just owning the stocks but greatly reduces volatility.  However, this strategy results in more short-term gains and should be implemented in tax free or tax deferred accounts.  Asset location choices must be balanced by the need for returns in different types of accounts (for example a desire for a higher return in retirement accounts) and liquidity needs (for example, the need for keeping some liquid assets in non-retirement accounts to be used in a time of need).