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Plan Well, Retire Well

Saving and investing your money

Asset Location


No, that's not a typo. Asset location is something that you may not have heard about, but it is an accepted practice that seeks to make your investments more tax-efficient, thereby increasing your real return.

In general, the idea is to hold your more tax-efficient investments (stocks, many stock mutual funds) in taxable accounts and less tax-efficient investments (bonds, real estate investment trusts) in tax-deferred or Roth accounts.

To understand how that works, think about the tax characteristics of stocks and bonds. The main way you make money on stocks is from an increase in value: you buy a stock and sell it at a higher price. That increase is a capital gain; if you owned the investment for more than one year, it's a long term (LT) capital gain. You pay a lower tax rate on LT capital gains than on ordinary income, such as your salary or interest on a CD. Currently, LT capital gains are taxed at either 15% for those in the 25% tax bracket or higher, or at 0% for those in the 10% and 15% tax brackets. Since you pay no tax until you sell, the tax is deferred. Together the lower tax rate and the deferral of the tax make stock investments very tax efficient, if they are owned for longer periods of time.

The same is true for mutual funds that invest in stocks, except that the mutual fund may sell stocks within the fund, generating a taxable gain even though you did not sell any shares of the fund. Stock mutual funds with low turnover rates are especially tax-efficient. Index funds and tax-managed funds generally have lower turnover than actively managed funds. You can check the turnover rate at Morningstar.com.

With bonds, your main source of income is interest, which is taxed as ordinary income. (Exception: Interest from municipal bonds is exempt from federal income tax.) As shown above, the tax rate on ordinary income is higher than the rate on LT capital gains and qualified dividends for every tax bracket – unless your income is low enough that you owe no tax.

Stocks are more tax-efficient than bonds for two reasons: income from stocks is taxed at a more favorable rate than the interest on bonds, and you don't pay tax on the increase in value until you sell the stock. As a result, you can delay the income and the tax for years or decades. In contrast, bonds generate interest income each year that is taxed at regular rates.

Now, let's think about the tax treatment of the types of accounts in which you might hold these investments.

  • Tax-deferred accounts (traditional IRAs; 401(k), 403(b), and 457 plans): Normally, you pay no tax on the money that you contribute to these retirement plans. When you take distributions from the account, it will all be taxed as ordinary income. Holding investments that result in capital gains inside these accounts causes those capital gains to be taxed at ordinary income tax rates rather than capital gains rates.
  • Roth accounts (Roth IRAs, designated Roth 401(k) and Roth 403(b) accounts): you have already paid tax on the money you contribute. For qualified distributions (the account has been open at least 5 years and you are either age 59 Ã?½ or older, disabled, or you are deceased), there is no tax on the growth in the account. Distributions of your contributions are always tax-free, as you have already paid tax on them.
  • Regular (taxable) accounts: this includes any investments or savings that are NOT held inside retirement accounts or annuities. You might have a CD at the bank, a brokerage account, or an account with a mutual fund company. Any income generated in these accounts will be taxed that year. When you die, your heirs will get a step-up in basis and will only owe tax on any increase in value since your death. Retirement accounts do not get a step-up in basis.

The concept of asset location combines these two sets of facts – the tax treatment of different types of investments and the tax attributes of different types of accounts – to arrive at a tax-efficient way of allocating different types of investments to different types of accounts.

Interest on bonds and bond mutual funds will be taxed at ordinary rates anyway, so holding them in tax-deferred accounts does not increase the taxes you will owe. You gain deferral of those taxes, since you have paid taxes each year on the income from those bonds. So there is a net tax benefit to holding bonds inside retirement accounts.

Mutual funds and stocks that you hold for the long term allow you to defer taxes until the sale, so owning them inside tax-deferred retirement accounts does not add a lot of tax benefit. And as noted above, holding stocks and bonds inside tax-deferred accounts converts their capital gains into ordinary income, subjecting them to higher tax rates.

Putting all that together, financial planners and academics generally agree that have holding your bonds and bond funds in tax-deferred accounts, and your stocks and low-turnover stock funds in taxable accounts is more tax-efficient and will result in greater returns from your investments.

For younger savers, one source says the strategy could result in a nest egg that is 20% greater.

How much you will benefit depends on your age or how long you have to benefit from the strategy, the difference between ordinary income tax rates and capital gains tax rates (if any), and the amount of return generated by the investment. If returns are low, it won't matter very much where the asset is located.

If you'd like to know more, two research articles may be of interest: Asset Location: A Generic Framework for Maximizing After-Tax Wealth by Gobind Daryanani and Chris Cordaro, and Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing by Robert M. Dammon, Chester S. Spatt, And Harold H. Zhang.

Check back in a week or two for another post on this topic, where I'll try to walk you through a practical application of this idea.


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69 years old. Asset allocation short on bonds. Will have to draw on IRA in one year and have excess cash in IRA. Adviseable to buy bonds vs more stock (have a lot of that) in an increasing interest rate environment -any advantage to bond over stock or vice versa?
by Gerald Bograd on Tuesday 5/24/2011

Bonds and stocks typically do perform differently in an economy with increasing interest rates. This may be an excellent time for you to visit with a financial professional who can look at your overall portfolio and your personal goals. U of I Extension's website, Choosing a Financial Professional at http://web.extension.illinois.edu/financialpro, has information that can help you find a professional who matches your needs.
by Kathy Sweedler on Wednesday 6/1/2011