Last updated: May 15, 2024
How asset location can help minimize taxes and maximize returns
Apr 19, 2023 Core
KEY TAKEAWAYS
- When investing for retirement, it’s critical to stay focused on what really matters — after-tax returns, or the profits left over after any tax payments.
- The higher your tax rate, the more you could lose if your assets are not held in the right accounts and it’s critical to understand which assets are best held in taxable vs. tax-exempt vs. tax-deferred accounts.
- Consider talking to your advisor or accountant about where to place certain investments in 401Ks, IRAs and other accounts to help limit your future tax burden.
WHAT IS 'ASSET LOCATION'?
“Location, location, location” is the most important thing in real estate, or so the saying goes. The same is arguably true in investing because where you keep assets can be as important as what you’re investing in.
Based on the principle that what really matters are after-tax returns, most investors could benefit from following this basic breakdown of where to put certain types of assets:
- Taxable Accounts: Traditional brokerage accounts are funded with post-tax dollars and your investment earnings will be taxed both during the accumulation phase and upon withdrawal. Consider anchoring these accounts with core equity ETFs, which tend to be tax-efficient, and municipal bonds which are generally exempt from federal taxes.1
- Tax-Deferred Accounts: Use 401Ks, traditional IRAs and similar accounts to hold less tax-efficient assets. Taxable bonds, especially high yield, are well suited for tax-deferred accounts because more of their return tends to come from recurring income than capital gains. Tax-deferred accounts are generally not taxed during the accumulation period; however, because they are funded with pre-tax dollars, you will ultimately pay tax upon withdrawal at your ordinary income tax rate. The good news is that rate is likely to be lower after you’ve retired, assuming your gross income — or all income before taxes and deductions — is less than it was during your working years.
- Tax-Exempt Accounts: Accounts such as a Roth IRA are funded with post-tax dollars and therefore do not pay taxes during accumulation nor upon withdrawal, if certain requirements are met. This could be the ideal place to hold assets that may be less tax efficient and that you expect will generate high returns, such as stocks and actively managed funds. (Read more about key differences between traditional and Roth 401(k) accounts.)
Start with the big picture to help minimize tax costs
Sources: BlackRock, as of April 30, 2024. For Illustrative Purposes Only.
Chart description: This is a Venn diagram showing what types of assets are most efficient in taxable vs. tax-exempt vs. tax-deferred accounts.
As a general rule, the higher your tax rate, the more you could lose if your assets are not held in the right accounts. It’s also important to remember not all assets are treated equally for the purposes of taxation. When building a portfolio, investors may be able to keep more of what they earn by considering the different tax rates on investment income and holding less tax-efficient assets in tax-advantaged accounts like an IRA or 401k.
Take bonds, for example. Treasury yields are near multi-decade highs and that’s great for investors seeking income. In addition to providing a good yield, high quality bonds can also help investors reduce risk by diversifying a portfolio.
But income from bonds can be taxed at different rates than other investments. Interest from most bonds is taxed as ordinary income which can have a rate as high as 40.8%, while the highest rate applied to qualified dividend income from stocks is 23.8%. 2-year U.S. Treasury bonds were recently yielding around 5% which represents a higher yield than other short-term vehicles, like CDs and money market funds, while carrying less risk than equities.2 Investors can keep more of that potential income if the bonds are kept in a tax-advantaged account, as shown in the table below.
Asset location helps reduce taxation
| Pre-tax yield | After-tax yield³ | |
|---|---|---|
| 2-year US Treasury Bond | 5.0% | 3.0% |
| US Stocks | 1.4% | 1.1% |
| Short-term Muni Bonds | 3.6% | 3.6% |
For Illustrative Purposes Only. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
CONCLUSION
Taxation hurts twice: When you pay, of course, and then over time as you’re left with fewer dollars to benefit from compounding growth. Paying higher taxes today means less money remains invested for the future, and less opportunity for growth.
Whether you’re already filed taxes for 2023 or have been granted an extension, consider talking to your advisor or accountant about where to place certain investments to help limit your future tax burden.
While individual circumstances can vary, the higher your tax rate, the more you could lose if your assets are not held in the right accounts. ‘Location, Location, Location’ is not just for real estate.
