Asset location is a high value way of increasing your after-tax return by holding investments in accounts with optimal tax treatment.  The term is often confused with asset allocation (which involves the selection of the investments).  Asset location only considers where those investments are held.  The three groups of tax classification are:

1. Tax-as-you-go
2. Tax-deferred
3. Tax-free

Let’s explore the different tax classification groups and which investments are most suitable for each group.

Tax-as-you-go

Example account type: Brokerage account

You pay tax as you earn your investment income in this account group.  You pay ordinary income tax rates unless you qualify for a reduction in taxes.  Dividends can be subject to qualified dividend tax treatment which allows a lower tax rate.  Most interest will be taxed as ordinary income. When you sell an investment you realize a capital gain and are taxed at the time you sell.  Most investments you not taxed on the gain in price appreciation until you sell the investment. If you hold the investment longer than one year you are eligible for long-term capital gains rates.  To be sure, there are other rules that govern the tax rates you will pay, so always consult with your tax professional before making these decisions.

Most suitable investments: Non-dividend, high-growth stocks; municipal bonds; long-term investments

Non-dividend, high-growth stocks benefit from this account group because there won’t be any income to tax along the way.  Of course, high-growth companies tend to mature into low-growth, dividend-paying companies.  Hopefully by then you have a large built-in capital gain which will soothe the sting of your dividend income tax.

Municipal bonds are also useful in tax-as-you-go accounts because they are generally exempt from income tax.  This is the only logical account type for municipal bonds.  Tax-deferred and tax-free accounts do not offer any additional benefit.

Long-term investments are very suitable for tax-as-you-go accounts because they avoid capital gain tax as long as you hold them.  You can time the sale to the most advantageous moment for you.

This account group is also suitable for high-dividend, low-appreciation stocks, if you do not have the risk appetite for high-growth stocks.  You still benefit from qualified dividend tax treatment and long-term capital gain tax treatment.

Tax-deferred

Example account type: Traditional IRA, 403(b), 457, Traditional 401(k), SEP IRA, SIMPLE IRA

This account group offers a tax deduction as an incentive to save for retirement.  You receive a tax deduction now and pay taxes on the contribution and investment income when you withdraw the money.  All withdrawals are taxed at ordinary income rates.

Most suitable investments: High-dividend, low-appreciation stocks; ordinary bonds; short-term investments

High-dividend, low-appreciation stocks will be shielded from taxes over the years.  You sacrifice the qualified dividend and long-term capital gain tax treatment, but this is preferable if you also have high-growth stocks in your portfolio.

Ordinary bonds thrive in the tax-deferred environment.  They are subject to ordinary income taxes anyway, so you might as well defer that burden as long as possible.

Short-term investments are very suitable for tax-deferred accounts because you can change your holdings without immediate tax consequence.

Tax-free

Example account type: Roth IRA, Roth 401(k), 529 (as long as you use the money for qualified education expenses), HSA (as long as you use the money for qualified medical expenses)

This account group offers a tax-free growth as an incentive to save for retirement or pay for qualified education and medical expenses.  You pay your taxes now and never again when you withdraw the money.

Most suitable investments: High-growth stocks; short-term investments

High-growth stocks benefit the most from this account group.  You can earn an unlimited amount of tax-free earnings and you should make the most of it by putting your most aggressive investments in this group.

Short-term investments are very suitable for tax-free accounts because you can change your holdings without immediate tax consequence.

You can implement this yourself, but asset location is a more advanced technique than other financial planning tools.  This strategy is better suited for professionals than the layman investor.

Sherman Asset Management does not provide tax or legal advice.  The information contained herein is provided for informational purposes only.  Do not rely solely upon this information to make tax decisions.