Are you invested in the right kind of accounts?
See how tax-smart asset location can potentially help improve after-tax returns.
By Fidelity Wealth Management
Key Takeaways:
- An investing strategy called asset location has the potential to help lower your overall tax bill.
- Know the differences between taxable, tax-deferred, and tax-exempt accounts.
- By putting tax-inefficient investments in tax-deferred or tax-exempt accounts rather than in taxable accounts, you can potentially improve the overall tax efficiency of your investments.
In real estate, it’s location, location, location. In investing, the same bit of wisdom also has a place. Where you put your investments — meaning the type of account you choose — can make a major difference in how much you can earn, after tax, over time. That’s because different investments are subject to different tax rules, and different types of accounts have different tax treatment. Sorting your investments into different accounts — a strategy often called asset location — has the potential to help lower your overall tax bill.
Should you use your brokerage account for the real estate investment trust (REIT) fund you are investing in, or would it be better in your tax-deferred annuity? What about the growth stocks you have been eyeing or the municipal bonds you are laddering toward retirement income—should those go into a Roth account or into your taxable account?
“You can’t control market returns, and you can’t control tax law, but you can control how you use accounts that offer tax advantages — and good decisions about their use can add significantly to your bottom line,” says Matthew Kenigsberg, Vice President, Investment & Tax Solutions at Fidelity Investments. While tax treatment is important, investors should start with a strategy for the mix of investments they will own. That asset allocation strategy should be based on goals, financial situation, risk tolerance, and investment horizon. Once your asset allocation is in place, asset location may be worth considering to help improve after-tax returns.
Know the 3 main types of investing accounts
Many investors have several different types of accounts that can be aligned with specific investing goals. Some are subject to taxes every year, while others have tax advantages. Here are the 3 main investment account categories:
- Taxable accounts such as traditional brokerage accounts hold securities (stocks, bonds, mutual funds, ETFs) that are taxed when you earn dividends or interest, or you realize capital gains by selling investments that went up in value.
- Tax-deferred accounts like traditional 401(k)s, 403(b)s, annuities, and IRAs allow payment of taxes to be delayed until money is withdrawn, when all or a portion of it is taxed as ordinary income.
- Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s, require contributions to be made with after-tax dollars and do not provide a tax deduction up front, but they allow the investor to avoid further taxation (as long as the rules are followed). Fully tax-exempt accounts such as health savings accounts (HSAs), allow you to make pretax or deductible contributions, earnings, or withdrawals, if used for qualified health expenses.1
Remember, contribution limits2 defer taxes on earnings and take tax-free withdrawals, preventing investors from simply saving everything in tax-advantaged accounts.
Asset location in action
Let’s look at a hypothetical example. Say Adrian, age 40, is thinking about diversifying his portfolio by investing $250,000 in a taxable bond fund. For this example, we will assume Adrian pays a 35.8% marginal income tax rate on net investment income and the bond fund is assumed to earn a 6% rate of return each year—before taxes. (Actual rates of return may vary.)
In what account should he hold the investment? The answer matters and can mean the difference between paying taxes annually and deferring them until withdrawal.
Suppose Adrian has 2 accounts with sufficient assets to choose between, to hold the investment. One is his taxable brokerage account where interest earned on the investment will be taxed annually; the other is a traditional IRA he has been making after-tax contributions to for many years. Since Adrian began contributing to the IRA midway through his career, he never made any tax-deductible contributions. If Adrian chooses to hold the investment in the tax-deferred IRA, the return on his investment, after-taxes, could be nearly $72,000 greater than it would be in the taxable account when he begins withdrawals 20 years later at age 60, assuming his tax rate remains the same.
Tax deferral has the potential to make a big difference for investors—especially when matched with investments that may be subject to high tax rates, as interest on taxable bonds can be.
Tip: Some high-income investors, who have already taken full advantage of tax deferral through workplace plans like 401(k)s and/or IRAs, may look to obtain additional tax deferral. They may benefit from the use of low-cost deferred variable annuities, which can bring a variety of benefits, and facilitating asset location is one of them. However, there are also tradeoffs and restrictions to think about, so consult with an investment professional or tax advisor before purchasing. Read Viewpoints on Fidelity.com: Create future retirement income
Can you benefit from an active asset location strategy?
There are 4 main criteria that tend to indicate whether an asset location strategy may be a smart move for you. The more of these criteria that apply to your situation, the greater the potential advantage in seeking enhanced after-tax returns.
- You currently pay a high marginal income tax rate: The higher the marginal income tax rate you currently pay, the bigger the potential benefits of asset location. Remember, as you earn more money, you may move into a higher marginal tax bracket. Consequently, the benefit of your additional income can be significantly reduced if you are being taxed at a higher marginal tax rate.
- You expect to pay a lower marginal income tax rate in the future: If you expect your marginal income tax rate to be lower in the future than it is now, active asset location may allow you not only to defer your taxes but to reduce them as well. Note that it is very common for investors to see their marginal income tax rate fall following retirement, and if you have assets with a time horizon into retirement, this may well be the case for you.
- You have significant assets in tax-inefficient investments held in taxable accounts: The more tax-inefficient investments, such as taxable bonds and taxable bond funds, you’re currently holding in taxable accounts (see chart, below), the greater the potential to take advantage of asset location.
- You are investing for the long term: Asset location strategies generally take time to work. While small tax benefits may be realized year over year, sizable benefits may be realized by allowing potential tax savings to compound. If relocating assets in a taxable account, you may incur initial tax costs when implementing an asset location strategy and it may take time for the benefits to outweigh the costs.
Rate your investments on a tax-advantages scale
If you are in a position to benefit from an asset location strategy, you have to choose which assets to assign to your tax-advantaged accounts and which to leave in your taxable accounts.
In general, the following are higher on the tax-advantaged scale:
- Individual stocks are, as a general rule, relatively tax-advantaged if bought and held for longer than a year.3
- Equity index mutual funds and ETFs are generally quite tax-advantaged.
- Tax-managed equity funds (that is, equity funds that name tax management as an explicit goal) tend to be highly tax-advantaged.
In general, these are lower on the tax-advantaged scale:
- Bonds and bond funds (with the exception of municipal bonds and funds, and US Savings Bonds) are generally highly tax-disadvantaged, because they generate interest payments that are taxed at relatively high ordinary income rates. Potentially higher returning types of bond investments, such as US high yield and emerging markets bond funds, are the most tax-disadvantaged.
- Actively managed stock funds with high turnover rates are less tax-advantaged because they tend to have high rates of capital gain distributions. They sometimes even distribute short-term capital gains, which are taxed at the higher ordinary income tax rates.
Locate investments where they may help enhance after-tax returns
So, which investments do you put where to help enhance after-tax returns? Each person will have to find the right approach for their particular situation. But generally, depending on your overall asset allocation, you may want to consider putting the most tax-advantaged investments in taxable accounts and the least in tax-deferred accounts like a traditional IRA, 401(k), or a deferred annuity, or a tax-exempt account such as a Roth IRA (see chart).
To get going, consider first checking to see whether you’ve already taken full advantage of a 401(k) plan, Keogh, IRA, or other qualified retirement accounts that may be available to you. To implement asset location, you need a variety of accounts with different tax treatments. Focus first on taking advantage of tax benefits available to you. Once you hit contribution limits or shift contributions to account types with different tax treatment, asset location can be used to further enhance after-tax returns.
“Investors should start out with a solid plan for their asset allocation, but within that framework, having a good strategy for where you keep your investments can be important,” says Kenigsberg. “By putting certain less tax-advantaged investments in a tax-deferred or tax-exempt account, you can potentially save a significant amount of money on taxes, which may help you improve your bottom line as an investor.”
Remember, the process of developing an asset location strategy is complicated, so consider working with a financial professional who can assist you with asset location as well as working with you to develop a solid financial plan to help you reach your financial goals.
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Footnotes:
1. With respect to federal taxation only. Contributions, investment earnings, and distributions may or may not be subject to state taxation.
2. 2022 contribution limits
• $6,000 to a Roth or traditional IRA. If you’re 50 or older, the limit is $7,000.
• $20,500 to a 401(k)/403(b) or $27,000 if you’re 50 or older.
• If you have a 401(k) match, the combined limit is $61,000, or $67,500 if you’re 50 or older, or 100% of your salary if it’s less than the dollar limits.
3. This is because capital gains on the sale of stocks held for more than a year are currently taxed at a top federal rate of 23.8% (this includes the top long-term capital gain rate of 20% plus the 3.8% Medicare surtax on net investment income). Investors with lower taxable income would pay rates of 18.8%, 15%, or even, in some cases, 0%.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP’s shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.
Investing in a variable annuity involves risk of loss – investment returns, contract value, and, for variable income annuities, payment amounts are not guaranteed and will fluctuate.
High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
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