How to Position Your Investment Portfolio for Tax Advantages

Editor's Note: This story originally appeared on NewRetirement.

In the complex world of personal finance, asset location is the hidden strategy that smart investors use to gain a distinct advantage.

Most people know to diversify their investments across different asset types to create the right asset allocation.

But, not everyone has an asset location strategy — consciously distributing their money across different tax treatments.

What Is Asset Location?

Where asset allocation establishes your investment mix across asset classes, asset location involves distributing specific assets between taxable, tax-deferred and tax-exempt accounts to minimize taxes and maximize your portfolio’s after-tax returns.

It has the potential to enhance your portfolio’s performance and minimize your tax burden.

In an era where smart financial decisions are paramount to achieving your financial goals, understanding asset location is an essential tool in the arsenal of every investor. By allocating your assets strategically, you can potentially:

• Reduce your overall tax liability.
• Increase after-tax returns.
• Accelerate the path to financial independence.

Understanding Tax Treatment on Your Accounts

Different types of accounts have different tax treatments. You can think of taxable, tax-deferred and tax-exempt accounts as three “tax buckets.”

Taxable Accounts

Taxable accounts are usually brokerage, investment or other accounts that do not have specific tax advantages.

• The money you put into a taxable account is after-tax money. After-tax money is money that has already been taxed and the remainder is available to spend or save.
• You also pay tax on the growth. Interest and dividends that your funds generate and any capital gains you realize are taxable in the year in which they occur.
• Interest, non-qualified (ordinary) dividends and short-term capital gains are taxed at ordinary income rates while realized long-term capital gains and qualified dividends are taxed at preferential rates.

Tax-Deferred Accounts

Tax-deferred accounts include traditional IRAs, 401(k)s and more. These savings vehicles give you immediate tax advantages.

• They are funded with pre-tax money. You invest your earnings without having to pay taxes on those funds.
• Growth is tax-deferred, which means you only pay taxes when you withdraw the money.

Tax-Exempt Accounts

Tax-exempt accounts include Roth IRAs, Roth 401(k)s, and others. These accounts give you future tax advantages.

• They are funded with after-tax money, money you have paid taxes on.
• Neither growth nor qualified distributions are taxed.

Asset Location Guidelines and Strategies

Asset location strategies involve strategically placing specific investments in various types of accounts (taxable, tax-deferred or tax-free) to maximize after-tax returns and minimize overall tax liability.

Here are a few considerations.

Invest tax-efficient assets in taxable accounts

A tax-efficient asset is an investment or financial instrument that is structured or managed in a way that minimizes the tax liability associated with it.

These assets are designed to generate income, capital gains or other returns while reducing the impact of taxes, allowing investors to keep more of their earnings.

Tax-efficient assets are particularly important for individuals seeking to maximize after-tax returns and minimize their tax burden. The following tax-efficient investments would generally fit well in taxable accounts:

• Tax-exempt municipal bonds: Exempt from federal taxes and sometimes state as well.
• Index funds and ETFs (exchange-traded funds): Generally low turnover of holdings with minimal capital gain distributions. Most of their return is from price appreciation which is not taxed until the funds are sold.
• Cash and cash equivalents: In a low-interest rate environment, these investments generally yield minimal interest income subject to taxes.
• Qualified dividend stocks: Hold qualified dividend-paying stocks in taxable accounts, as they are often subject to lower tax rates.

Put less tax-efficient assets in tax-advantaged accounts

The following investments are generally less tax-friendly and would typically be well-placed in tax-advantaged accounts:

• Actively managed stock funds: These funds generally have a higher turnover of stocks within their portfolios as fund managers actively buy and sell assets to meet their investment objectives, generating large taxable gains, some of which may be short-term gains, which are taxed at less favorable rates.
• Government and corporate bond funds: Most of the return from these investments come from interest (sometimes called a dividend yield), which is taxed annually at your ordinary income tax rate. Tax deferral can help to avoid paying ongoing income taxes on the interest, allowing a greater portion of your money to remain invested and to grow within the account.

Asset location can play an important part in tax-efficient investing. It allows you to keep more of your investment returns by accounting for how different assets are taxed in different accounts.

Evaluating and modifying your asset location is a prudent strategy when goals, income or tax brackets change.

Be strategic about how you use money from taxable accounts

If you hold a taxable account in your investment portfolio, you may want to consider exploring a few tax planning opportunities that could benefit you:

• Tax loss harvesting: Sell investments that have declined in value to realize capital losses in taxable accounts. These losses can be used to offset capital gains and reduce your taxable income.
• Estate planning: When passing assets to heirs, consider the step-up in cost basis that can occur with taxable investments. This can minimize the capital gains tax liability for your beneficiaries.
• Tax-efficient charitable giving: Consider donating appreciated assets from taxable accounts to charities, which can provide a double benefit: a tax deduction for the donation and avoidance of capital gains taxes.

Consider ‘relocation’

Just like you can shift your asset allocation, you can sometimes also switch your asset location to optimize for taxes:

• Roth IRA Conversions: Convert funds from a traditional IRA to a Roth IRA over time. This involves paying taxes on the amount converted, but once in the Roth IRA, the assets can grow tax-free and be withdrawn tax-free in retirement. Be cautious of the tax implications when performing conversions. Use NewRetirement’s Roth Conversion Explorer to get different kinds of personalized conversion strategies.
• Tax-Efficient Withdrawals: When you’re retired or in a lower tax bracket, consider withdrawing money from tax-deferred accounts like traditional IRAs or 401(k)s before tapping into taxable accounts. This strategy can help manage your overall tax liability.
• In-Kind Transfers: Transfer investments in-kind (without selling them) from one account to another. This can be useful for shifting tax-efficient assets to taxable accounts or tax-inefficient assets to tax-advantaged accounts.
• Qualified Charitable Distributions (QCDs): If you’re 70½ or older and have an IRA, consider making charitable donations directly from your IRA. QCDs can satisfy your Required Minimum Distribution (RMD) and reduce your taxable income.

Prioritize asset allocation over asset location when reviewing investments

Since your mix of stocks, bonds and cash drives the vast majority of investment returns over time, it’s important to keep asset allocation decisions a top priority.

Asset location focuses on tax efficiency, and, while beneficial, the tax impact is secondary to asset allocation in its effect on total returns for the typical investor.

While asset allocation should be the primary focus, asset location can provide value, especially for larger investment portfolios with multiple tax buckets as discussed previously.

Strategic placement of investments across taxable and tax-advantaged accounts can further boost after-tax returns. However, in the end, it’s the asset allocation, not location, that should steer your overall investment strategy.