Asset localization is a tax minimization strategy that takes advantage of the fact that different types of investments receive different tax treatments. Using this strategy, an investor determines which securities should be held in tax-deferred accounts and who in taxable accounts to maximize after-tax returns. Who can benefit from this investment strategy, how can locating assets minimize taxes, and what is the best way to locate assets?

Achieve the optimal location of assets

Locating Assets, While Lowering Taxes, Does Not Replace Assets allocation, which positions stocks, funds and other holdings in a portfolio across different sectors to cushion market declines. Only after determining the appropriate asset mix for your portfolio can you position these investments in the appropriate accounts to minimize taxes.

The best location for an investor’s assets depends on a number of different factors, including financial profile, applicable tax laws, investment holding periodsand the tax and yield characteristics of the underlying securities.

Tax-friendly stocks should be held in taxable accounts due to their lower capital gains and dividend tax rates and the ability to defer gains. Riskier and more volatile investments belong to taxable accounts both because of the ability to defer taxes and the ability to capture tax losses on poorly performing investments sold at a price recognized loss.

Index funds, as well as exchange-traded funds (ETFs), are assessed for their tax efficiency and should also be held in taxable accounts, much like tax-exempt or tax-deferred bonds. Taxable bonds, real estate investment trusts (REITs) and related mutual funds should be held in tax-deferred accounts, like any mutual fund that generates high annual capital gains distributions.

Who benefits from asset location?

To benefit from this strategy, investors must have investments in taxable and tax-deferred accounts. Generally, investors who use a balanced investment strategy compounds of equities and fixed income securities can make the most of asset localization. Investors whose portfolios are only fixed income securities or equities can still benefit, but not to the same degree.

A typical investor with a balanced portfolio of 60% stocks and 40% bonds may hold investments in both taxable and tax-deferred accounts. Although the investor’s overall portfolio should be balanced, each account need not 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 provide the best after-tax return.

For example, an investor whose asset mix is ​​40% fixed income and 60% equity will yield the maximum profit if the tax-deferred account holds 40% and the taxable accounts hold 60% of the total assets. In this case, transferring all fixed income investments to the non-taxable account and all stocks to the taxable account will provide the maximum benefit.

If an investor is withdrawing funds from tax-deferred accounts or will do so soon, the advantage of asset location is greater than for younger investors who still have many years to go before they start withdrawing funds.

Suppose an investor has accumulated $20,000 in capital gains and dividends in a traditional Individual Retirement Account (IRA). The investor takes the full amount as a distribution, which is then treated as ordinary income.If the taxpayer falls into the 35% tax bracket, the investor would end up with $13,000.If the investor had realized $20,000 of long-term capital gains and eligible dividends in a taxable account, the tax would have been only 15%, leaving $17,000. 

How Asset Location Minimizes Taxes

How a title is taxed will determine where it should be located. Long-term capital gains and eligible dividends benefit from favorable rates of 0%, 15% or 20%, depending on your level of income.  During this time, taxable interest is declared on Form 1040 and is subject to ordinary rates of income, which vary between 10% and 37%. 

Since most equity investments generate both dividend and capital gains returns, investors realize lower tax bills when owning stocks or shares. mutual fund in a taxable account. However, those same capital gains and dividends would be taxed at the ordinary rate (up to 37%) if withdrawn from a traditional IRA, 401(k), 403(b)or another type of retirement account where taxes are paid on the withdrawal of funds.  

Fixed income investments such as bonds generate regular cash flow. These interest payments are subject to the same ordinary tax rates of up to 37%. 

The essential

The location of the assets determines the appropriate account in which to place the investments for the most favorable overall tax treatment. The best location for a particular security depends on the investor’s financial profile, applicable tax laws, investment holding periods, and the tax and yield characteristics of the underlying securities.