Forex

Asset location is a tax minimization strategy that takes advantage of the fact that different types of investments get different tax treatments. Using this strategy, an investor determines which securities should be held in tax-deferred accounts and which securities should be held in taxable accounts in order to maximize after-tax returns. This article will explain who can benefit from this investment strategy, how asset location minimizes taxes and the optimal way to locate assets.

Who Benefits From Asset Location?
For investors to benefit from this strategy, they must have investments in both taxable and tax-deferred accounts. Investors with assets split between taxable and nontaxable accounts and with similar asset mixes will get the largest benefit from asset location. For example, an investor with an asset mix of 40% fixed income and 60% equity will achieve the maximum benefit if the tax-deferred account holds 40% and the taxable accounts holds 60% of total assets. In this case, moving all fixed-income investments into the nontaxable account and all equities into the taxable account will provide the maximum benefit.

Typically, investors who use a balanced investment strategy consisting of equity and fixed-income investments can get the most benefit from asset location. However, those investors with all fixed income or all-equity portfolios can still benefit, albeit not to the same degree.

If an investor is withdrawing funds from tax-deferred accounts or will be doing so in the near future, the benefit of an asset location strategy is greater than it would be for younger investors with many years left before they will start withdrawing funds. As an example, assume an investor made $20,000 in capital gains and dividends in a Traditional IRA during the past year and withdrew the same amount. At the top tax bracket, these earnings would be taxed at 35%, leaving the investor with $13,000. If the investor made $20,000 in capital gains and dividends in a taxable account, the tax would have been only 15%, leaving $17,000. (For related reading, see Not All Retirement Accounts Should Be Tax Deferred.)

How Asset Location Minimizes Taxes
A typical investor with a balanced portfolio consisting of 60% stocks and 40% bonds might hold investments in both taxable accounts and tax-deferred accounts. Although the investor's overall portfolio should be balanced, each account does not need to have the same asset mix. Creating the same asset allocation in each account ignores the tax benefit of properly placing securities in the type of account that will assure the best after-tax return.

How a security is taxed will determine where it should be located. Under the 2008 tax code, dividends and capital gains get favorable treatment. While interest income gets taxed at a 35% rate for investors in the highest tax bracket, the tax rate for dividends and capital gains is only 15%. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account. Those same capital gains and dividends, however, would be taxed at the ordinary rate (up to 35%) if withdrawn from a traditional IRA, 401(k), 403(b), or other type of retirement account where taxes are paid on the withdrawal of funds.