You know how important it is to diversify your investment portfolio. You spread your investment dollars across several types of investments because you don’t want to have all of your proverbial eggs in the same basket. We suggest diversifying across several categories, or asset classes, because the different asset classes perform differently. But it’s also important to diversify your portfolio by diversifying across account types.
There are several types of accounts you can invest in. For example, there are individual and joint accounts, trust accounts, IRAs, 401(k)s, and Roth IRAs. In a previous post, “The 3-Bucket Approach to Retirement Savings,” I discussed the importance of having different “baskets” of money to draw upon in retirement. It’s good to have a pool of after-tax, tax-deferred, and tax-free funds to draw on. It’s a strategy that allows you to exert some control over the taxes that you pay.
Another way to control the taxes that you pay is to use a strategy called “asset location.” It involves diversifying your investments according to the type of account. To implement this strategy, we must understand a couple of things. First, it’s important to know the different ways we make money on our investments. Fixed-income, or bond, investments typically pay interest and/or dividends. Stock-based investments may pay some dividends, but the main way we make money on them is through capital gains. We buy them at one price and hopefully sell them at some point at a higher price.
Next, it’s important to understand that different types of income are taxed in different ways. Interest and dividends are taxed at ordinary income rates. This means that the total amount you earn in interest or dividends is added to your other sources of income (employment, pension, IRA distributions, Social Security benefits, etc.) to determine your tax bracket. Capital gains are taxed differently. If you hold an investment for over a year and sell it for a profit, it is considered a long-term gain. Depending upon your tax bracket, capital gains are taxed at 20%, 15%, or possibly 0%.
The strategy works by placing the investments that are going to be taxed at higher, ordinary income rates inside a tax-deferred account, like an IRA or 401(k). The investments that will generate capital gains should be in your post-tax accounts, like your joint or trust account. This means that your bond-type investments will be in your tax-deferred accounts, and the regular interest and dividends you earn will not be currently taxed. Your stock-type investments will be in your taxable accounts, where any gains are taxed at the lower capital gains rates.
It’s important to note that this is an oversimplified example to illustrate the concept of asset location. In reality, it’s not that simple. It’s rare that your accounts are the exact size that you need so that your IRA doesn’t hold stock-type investments. And your taxable accounts will need to have some cash and bond-type investments to meet your liquidity needs. You also need to understand that the performance of the accounts will be dramatically different. If you put growth-oriented investments in your taxable account, and fixed-income investments in your IRA, your IRA will likely lag from a performance standpoint. But this turns into a benefit later, when you start taking your required minimum distributions at age 70. A smaller account balance results in lower distributions—another way to control your tax consequences.
The goal of the strategy is to place your investments in the type of account that will maximize your after-tax return. After all, it’s what you end up with after taxes that you get to spend. Asset location is not an easy strategy to implement or maintain, but if it can increase your spendable income in retirement, it’s worth it. For help in seeing how it would work in your case, don’t hesitate to reach out.