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How Asset Location Can Help Fatten Your Nest Egg

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

The U.S. tax code is overly complex, not just for the income you earn working in your career, but also for the income you earn from your investments.

The good news is that by understanding the different tax treatment that applies to different investments—and account types—we can plan a tax-wise asset location strategy. And, successful asset location can significantly minimize the amount of taxes you pay on your investments as a whole. This can lead to a meaningful increase in your after-tax return—the money you get to keep, which is all that really matters.

Here's how it works:

As you may know, stocks that you own for longer than a year are taxed at lower capital gains rates. Short-term equities, as well as taxable fixed income, are taxed at higher, ordinary-income tax rates. Municipal bonds, meanwhile, are free of federal taxes and may be free of state and local taxes as well.

Asset location involves choosing which asset types to place in taxable accounts (such as brokerage accounts), tax-exempt accounts (such as Roth IRAs), and tax-deferred accounts (such as 401(k)'s and traditional IRAs).

In general, smart asset location involves placing the most tax-efficient investments in the least tax-efficient account type. Tax-free municipal bonds, for example, would be placed within a taxable brokerage account. That would leave room for tax-inefficient investments, such as taxable bonds, dividend stocks, or REITs to be housed in a tax-advantaged account.

Studies have shown that asset location can increase an investor's after-tax returns by as much as a half a percent annually. That may not seem impressive until it's multiplied over several years' worth of compounding. The tax savings can really add up.

Consider the following simplified example, calculated by Bank of New York Mellon. A 50-year-old investor has $5 million, with 60% of that invested in stocks and 40% invested in bonds. His federal tax rate is 35% and his state tax rate is 6%.

In Scenario A, the investor splits his assets evenly, with the same 60/40 ratio of stocks to bonds in his taxable account that he owns in his traditional IRA. In Scenario B, the investor places his taxable bonds first in his IRA, and his long-term stocks in his taxable account. Remember that bond income is taxed at a higher rate than long-term stock income.

Let's say the investor chose Scenario A, which was not optimized for asset location; he earns good returns and by age 70 has grown his assets to $17.7 million. Now let's say he chose Scenario B, which optimizes his asset location. Even with the same return, he's increased his assets to $18.9 million. Same return - $1.2 million more to spend.

Again, that's a simplified example, and not all investors will have the same result. But it does illustrate how tax savings, reinvested and compounded over time, can make a substantial difference in your ability to achieve your financial goals.

Bear in mind that an asset location strategy should be based on each individual's long-term goals, income tax bracket and asset allocation plan.

At Align Wealth Management, optimizing our clients' asset location is just one of the tax-management services we provide to every client. We also help our clients win the tax game by limiting short-term trading and by taking advantage of tax losses to neutralize the tax liabilities on taxable gains.

Please contact us at 800 401 6477 to learn how we can help you make the most of your one financial life. We're here to help.