Stock market returns receive all of the attention when it comes to investing. Turn on CNBC or any other business channel any day of the week and likely the first thing you will see are flashing green or red numbers in your face indicating whether the market(s) are up or down for the day. Some “expert” with an inflated ego will be talking about his forecast for the S&P 500. Investors are bombarded daily with news from legacy media, social media, and influencers. Open Twitter or TikTok and there are thousands of influencers bragging about their stock picking skills and how they quadrupled their investment in XYZ stock in a week (Pro Tip: Those same influencers don’t talk about investments they lost money on). The stock market receives all the glamor and spotlight for investment returns, but is it the only game in town for investors to maximize investment returns?
Don’t misconstrue what I am saying: Investment returns are still the most important thing for achieving financial objectives. Picking investments that are not suitable for individual specific goals or risk-tolerance is an almost assured way of causing investors to miss the target on achieving their slated objectives. However, investment planning strategies such as asset allocation and asset location are often ignored or simply not given the credence they deserve. I get it; planning strategies aren’t sexy. No one likes to brag to their friends about maxing out their 401(k). Think of planning strategies as the little things athletes do when no ones looking to become great. Planning strategies will never receive the recognition for the game winning goal, but they put the athlete in that position to score. When implemented correctly, asset location can save investors significant dollars by limiting tax, penalty and/or liquidity burdens.
Our last blog reviewed the investing concept asset allocation, which is diversifying investments across different asset classes to meet investor specific objectives based on quantitative and qualitative data. Asset location is the investing concept of allocating assets to specific account types, to maximize tax efficiency, while still meeting investor objectives. First we will look at several types of accounts based on their unique pros and cons. Then we will discuss various asset types and which accounts they are most suitable for. And finally we will explore asset location tax planning opportunities available to investors.
Account Types: The ins & OUts
Taxable accounts may also be referred to as non-qualified accounts or brokerage accounts. They can be registered as individual, joint, or business accounts. They are funded with after-tax dollars and are referred to as taxable accounts because all transactions are subject to income or capital gains taxation, if applicable, in the year they occur. Unlike tax-advantaged retirement accounts, there are no explicit tax benefits for taxable brokerage accounts.This means short-term and long-term capital gains, dividends, and interest payments are considered income, and taxed annually to the individual or entity. Because individual tax brackets can vary widely in the progressive U.S. income tax code, there is the potential for taxes from these transactions to eat away at a significant portion of investment returns on an annual and long-term basis. The holding period matters in a taxable account as long-term capital gains receive favorable tax treatment versus short term capital gains.
The main benefits of taxable accounts include no annual funding limitations like there are in place with Individual Retirement Accounts (IRA) and ERISA qualified retirement plans. This means individuals can contribute as much money annually to a taxable account as they desire. There are also the liquidity benefits of taxable brokerage accounts. Whereas retirement accounts have early withdrawal penalties (with certain exceptions) for distributions before age 59 ½, funds from a brokerage account can be withdrawn at any time without penalty. While these are not traditional savings accounts you’d utilize at a bank or credit union, they can be used to hold excess cash savings for emergencies and short-term goals, and often can have check writing capabilities. IRAs and ERISA retirement plans have restrictions on certain assets, such as collectibles, that cannot be held inside the account. Retirement plans also cannot be used as a loan mechanism for credit. Taxable accounts have these capabilities and therefore provide investors with ultimate investment flexibility.
Tax-deferred accounts include Traditional IRA and Traditional 401(k) accounts. Taxes on contributions and gains are deferred until funds are withdrawn. By deferring taxes, investors are able to reduce their current taxable income via payroll deductions into a 401(k) or by contributing to a traditional IRA and receiving a tax-deduction when they file. In addition, because the accounts are tax-deferred, the earnings continue to grow without the “tax-drag” that can occur in taxable accounts. The proceeds of every stock sale, dividend, and interest payment is able to be reinvested at its full value.
Tax-deferred accounts come with tax advantages, and they also come with restrictions. And while anyone can contribute to a 401(k) regardless of their income level, the deductibility of traditional IRA gets a little trickier, and is calculated based on a variety of factors including income level and availability of a workplace retirement plan such as a 401(k). There are also annual contributions limits. For 2023, the maximum deferral into a 401(k) plan is $22,500 and the maximum contribution into an IRA is $6,500 (these figures don’t include catch-up contributions for those over age 50). Withdrawals from tax-deferred accounts are also not tax-free. Distributions from tax-deferred accounts are subject to income tax and an additional 10% if the owner is not 59 ½, with exceptions. Tax-deferred accounts are also subject to the Required Minimum Distribution (RMD) rules at age 72.
Tax-free accounts include Roth IRA and Roth 401(k) accounts. Contributions to these accounts are made on an after tax basis. Contributions and earnings grow tax-free, and eligible distributions after age 59 ½ are tax and penalty free. Because eligible Roth distributions are tax-free, investors can withdraw money from these accounts and not worry about increasing their taxable income. Contributions are considered basis and can be withdrawn any time, penalty free, regardless of age. This is an added advantage Roth accounts have over traditional accounts. Tax-free accounts are not subject to the RMD requirements at age 72.
There are many benefits of tax-free accounts, however, like all tax-advantaged accounts they do come with limitations. They are not completely tax free in the sense they are funded with after-tax dollars. This means taxes have been already paid on contributions, often by investors in their highest earnings years while they are working. While contributions from tax-free accounts can be withdrawn at any time, earnings cannot be withdrawn tax-free and penalty-free until the account has been opened for at least 5 years and age 59 ½. Roth IRA and 401(k) accounts also come with the same aforementioned annual contributions limits that apply to their applicable tax-deferred counterparts. In addition, Roth IRAs come with contributions limits. Individuals that make over certain income thresholds are phased out and cannot directly contribute to Roth IRAs, however, there are ways around the income limit restrictions.
Tax efficient asset location: optimal assets for each account
Taxable accounts are the most tax sensitive accounts because dividends, interests and capital gains are not shielded from taxation. Because of this, asset selection is critical to preventing an unwelcome, and potentially unexpected, tax bill. Selecting assets that appreciate in value, pay qualified dividends, pay tax-free income, or are packaged in a tax-efficient mechanism are all ways to limit or avoid taxation.
Using passive investments like index mutual funds or ETFs (Exchange Traded Funds) is one of the simplest ways to minimize capital gains tax. Passive funds are investment vehicles that track an index, thus limiting turnover unless the index replaces a company. One common index that is tracked is the S&P 500 which tracks 500 of the largest companies in the United States. The lower turnover of indices means passive funds very rarely incur capital gains tax unless the investor chooses to sell their position which has appreciated in value. On the flip side are actively managed funds; not only do they charge higher fees and as a whole have historically underperformed their relative indices, but investors also lose some of the control over capital gains tax implications. The underlying professional investment manager that “actively” buys and sells securities inside the fund can cause capital gains tax to be paid out to shareholders of the fund. This can even happen in years when the stock market is down double digits, as we saw with many actively managed mutual funds in 2022 that paid out (sometimes large) capital gains distributions to shareholders. This doesn’t mean investors holding active mutual funds are capital gains taxed twice, they simply lose some of the discretion over when they incur the tax.
Municipal bonds are fixed income assets that are not subject to federal income tax and can be a way for high earners, in the highest income tax brackets, to reduce their federal tax liability. In addition to federal income tax exemption, if the investor resides in the state where the municipal bond is issued, it is typically state income tax exempt. Because they are not subject to federal (and state) income tax, Municipals usually come with lower interest rates than their equivalent rated taxable Treasury and Corporate bonds. It is important to compute the tax equivalent yield on municipal bonds to compare the tax-free interest rate of municipal bonds with the interest rate of taxable bonds. Municipal bonds would not be appropriate for tax advantaged accounts because the tax benefits are irrelevant.
Some types of Real Estate are beneficial to be held inside taxable accounts. Typically Real Estate is an income generating asset class and the distributions are taxed at higher income tax rates. Real Estate Investment Trusts (REITs) with a primary objective on capital appreciation, and REITs that distribute tax-preferred income to shareholders comprised partially of a return basis, would be two examples of holding real estate in taxable accounts that can minimize income taxation.
Tax-deferred accounts offer long-term tax deferral and therefore are great vehicles for accumulating wealth using tax-inefficient investments. These investments typically pay income as their primary objective and include taxable bonds, high-yield corporate bonds, and income focused real estate. Actively managed funds such as tactical funds that are tax-inefficient are also a good fit. High dividend, income-oriented stocks, are also appropriate for tax-deferred accounts because they pay out the majority of their return in the form of taxable dividends.
These assets are all taxed at ordinary income rates, with the exception of dividend stocks that pay qualified dividends at capital gains rates. Combined federal and state income tax rates ranging from 10-50% could eat away at as much as half of the return of these assets. Sheltering them inside a tax-deferred account enables every dollar earned by the investor to be reinvested. The effects of compounding are magnified the longer the assets stay inside the account.
Tax-free accounts like Roth IRAs and 401(k)s offer tax-free growth and tax-free withdrawals. Because no future taxes will be assessed on eligible withdrawals, they are the ideal vehicle for growth-oriented stocks, funds, and real estate. As is the case with tax-deferred accounts, tax-free growth enables every dollar to be reinvested and compounding to take place over long periods of time.
Tax-free accounts that have highly appreciated assets are able to be rebalanced without capital gains tax consequences. This means rebalancing Roth accounts on regular intervals is a prudent investment strategy that will continuously sell appreciated assets and invest the proceeds into underweight assets. At times, growth oriented assets will go through very quick periods of high growth. In the first half of 2023 the Russell 1000 Growth Index was up over 29%. In this same period the Russell 2000 Value Index returned less than 3%. Being able to rebalance assets that make substantial moves, tax-free, magnifies the effects of long-term compounding.
Planning opportunities and exceptions to the “rule of thumb”
Changes in income offer ample tax planning opportunities for investors to utilize the U.S. progressive tax code to their benefit and relocate assets to different accounts. The central idea is to create tax arbitrage; taking advantage of dynamic income levels throughout the lifecycle to maximize tax reductions strategies in high income years and tax “realization” strategies in lower income years. While planning around changing income levels is central to tax planning, the strategy each individual chooses to use also depends on their specific goals. For tax-sensitive investors with no heirs, tax-deferral may always be their preferred method of allocating monies. Individuals with heirs that are high earners may choose to do Roth conversions in their later retirement years to reduce the burden on beneficiaries.
Taxable accounts are exposed to capital gains tax, on both the federal and state level. As is the case with income tax, capital gains tax brackets are progressive. Where the two taxes diverge is the starting point. The lowest federal capital gains bracket is 0%. The lowest federal income tax bracket is 10%. This means investors below certain income thresholds can sell appreciated assets in taxable accounts and not pay any federal tax, as long as they have met the long-term capital gains tax holding period. Investors are able to “fill up” the 0% long-term capital gains bracket in years where there is a gap between their taxable income and the 15% floor. This is a great method for low income earners, recent college graduates, or retirees to take advantage of a benefit in the tax code geared toward their income demographic.
The U.S. tax code also has additional taxes levied on various wages and investments. These are not income or capital gain taxes. The Additional Medicare Tax and Net Investment Income Tax are levied on wages and investment income, respectively. These taxes are applied on top of any income and capital gains taxes that have already been assessed. The Additional Medicare Tax and Net Investment Income Tax are only applied to individuals (or Households) with income over specific thresholds. For individuals with income in the vicinity of the thresholds, tax-deferral may provide additional tax reduction in the form of avoiding these two taxes.
Taxable accounts do have one tax benefit over tax-advantaged accounts. In a taxable account, investments that are sold at a loss in value from their purchase price or become totally worthless, can be realized as a loss. This means, they can offset capital gains on other investments or even, to a limited degree, be used to offset ordinary income. As much as we would like, not every investment goes up in value. Being able to tax-loss harvest is a great tax planning tool if implemented properly.
Tax-free accounts are a great shelter for high growth assets, however, this can also be a double edged tax sword, so to speak. High growth assets, including speculative risk assets, come with substantial downside risk. Many times high-growth and speculative assets lose substantial value; sometimes they become worthless. In a tax-free account there is nothing investors can do but take it on the chin. This is a judgment call investors must make on high growth investments. The prospect of tax-free future growth versus the possibility of non-deductible losses on risk assets.
Requires Minimum Distributions (RMDs)
Required Minimum Distributions are, as the name suggests, required distributions from Tax-deferred IRA and 401(k) accounts. Currently, investors with assets in one of these accounts must start taking distributions at age 72. The exception being, if you are over 72 and have a 401k at your current employer, this 401k is exempt until separation from employment. The amount of the distribution is calculated off one of several IRS life expectancy tables. As people age and their life expectancy decreases, the distribution as a percentage of the account balance increases. The relationship between life expectancy and distribution percentage is inverse, and distributions can become rather large for people that live well into their 80’s and beyond. Because tax-deferred account distributions are taxed as ordinary income, older investors can be hit with hefty tax bills. The annual RMD cannot be left in the account; there is a 50% penalty on annual RMD amounts that are not distributed. Annual RMD distributions are not lost if the money is not immediately needed; it can be transferred into a taxable account and reinvested.
Roth IRA and Roth 401(k) accounts do not have mandated RMDs (Roth 401k does for 2023 but not for 2024 and beyond as part of SECURE Act 2.0) and can be a great tool to avoid RMDs. One strategy to reduce RMDs is to put in place a Roth Conversion schedule utilizing the aforementioned years with low income. Implementing a conversion schedule can drastically reduce annual RMD requirements that can balloon for certain investors in their later years.
While anyone should be grateful to receive a windfall, inheriting tax-deferred accounts can create a tax burden, especially for high income individuals. Tax-deferred assets must be distributed by beneficiaries according to an IRA schedule that depends on the beneficiaries relationship to the owner of the account. Beneficiaries have few options to limit income taxes on inherited accounts, but the same is not true for taxable and tax-free accounts.
A common method to minimize beneficiary taxation is for tax-deferred account owners to do Roth conversions. Not only does this remove the assets from RMD consideration, it also creates a tax-free inheritance for the owner’s beneficiaries that are likely in a higher tax bracket. Although there are IRS rules for exhausting an inherited Roth account, there are no income tax implications to the beneficiary.
Appreciated assets in taxable accounts receive a “stepped-up” basis when they are inherited by beneficiaries. On the day the account owner passes away, assets in a taxable account receive a stepped up basis to their fair market value on that date. The deceased owner could have a 100% gain on ABC stock, but the beneficiary will pay no capital gains tax if they were to sell ABC stock for the price it was on the date of death.
The power of asset location and proper planning can be an added boost to the long term compounding effect of investment portfolios. The Vanguard Advisor Alpha study suggests that working closely alongside an experienced financial planner to integrate asset location strategies can add up to 0.60% annually to investor returns. This can vary depending on an individual’s circumstances, but the main point is there is value in having a consolidated strategy across accounts, rather than viewing our investments as completely separate buckets of money.