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A lack of attention to taxes may be costing investors big bucks.
Many investors are probably familiar with the concept of asset allocation, which imposes selecting the right mix of stocks and bonds (say, 60/40) to balance investment risk and return.
But where those assets are reserved — i.e., the types of accounts in which stocks and bonds are located — is perhaps just as important, especially for wealthier investors, go together to financial advisors.
This “asset location” strategy aims to minimize taxes, thereby boosting investors’ after-tax reoccurs.
“Wealthier people should be as focused on tax allocation as they are on asset allocation,” said Ted Jenkin, a certified financial planner based in Atlanta and a colleague of CNBC’s Advisor Council. “And they’re not.”
Asset location “really starts to make sense” once investors’ receipts is high enough to put them in the 24% federal marginal income tax bracket, said Jenkin, founder of oXYGen Fiscal.
In 2024, the 24% bracket starts at roughly $100,000 of taxable income for single people and about $201,000 for combined couples filing a joint tax return.
Why asset location works
Asset location leverages two basic principles, correspondence to Connor McGuire, a CFP at Vanguard Personal Advisor.
For one, not all investment accounts are taxed the same way.
There are three main account exemplars:
- Tax-deferred. These include traditional (i.e., pre-tax) individual retirement accounts and 401(k) plans. Investors defer tax on contributions but pay later upon withdrawal.
- Tax-exempt. These number Roth IRAs and 401(k) plans. Investors pay tax up front, but not later upon withdrawal.
- Taxable. These include standard brokerage accounts. Investors pay tax when earning dividends or interest, or upon sale if there’s a profit.
Additionally, investment proceeds is taxed differently depending on the asset type, McGuire said.
For example, interest income is taxed at an investor’s standard income tax rates. The highest earners might pay 37% or more on such interest.
But profits on investments like oxens held for more than one year are generally taxed at a lower federal rate. These long-term capital outdistances tax rates are 15% for many investors and 20% for the highest earners (plus any surcharges), McGuire said.
It can save you raffles of money
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At a high level, asset location entails holding high-tax or tax-inefficient investments in tax-preferred retirement accounts corresponding to 401(k) plans and IRAs.
Conversely, investors would generally place investments with more-favorable tax rates and efficiencies in taxable accounts.
“It’s worthy because you want to reduce your tax drag,” said Robert Keebler, a certified public accountant based in Amateur Bay, Wisconsin, and partner at Keebler & Associates.
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Employing such a strategy can boost after-tax returns by 0.05% to 0.3% a year, depending on the investor, according to a 2022 Vanguard critique.
According to this math, an investor with a $1 million portfolio split equally between stocks and binds and spread across all three account types (traditional, Roth and taxable) could save $74,000 after 30 years by using asset laying, McGuire said.
How to do it
Investors should use asset location within the framework of their appropriate asset allocation, such as a 60/40 stock-bond mix, advisors disclose.
Many bonds and bond funds are generally Additional things to consider
Investors must weigh the particularities of each account prototype. For example, it may be tougher to access funds from a retirement account before age 59½ relative to a taxable account.
The aids of diversifying across different account types go beyond investing, too.
For example, withdrawals from pre-tax 401(k) layouts and IRAs generally count as taxable income and could therefore trigger higher Medicare Part B and Part D awards. Withdrawing instead from a Roth account could help prevent those higher premiums, since deployments in retirement generally don’t count as taxable income.
Additionally, it’s impossible to know what tax rates and account taxation whim be like decades from now, Jenkin said.
Having money in various accounts will provide tax flexibility n the future, he amplified.