One crucial strategy overlooked in investment management is asset location, which should not be confused with Asset Allocation, which is how many stock-to-bond ratios you own in your portfolio. However, asset allocation is the investment you put into what account to give you the best tax efficiency to achieve your goals and not have the tax drag bring down returns. A correct or more effective asset location could potentially increase returns between .30%-.60% (The Vanguard Group, Inc., 2020).
You can use an asset location strategy to optimize your investment portfolio for tax efficiency. This involves placing different types of investments in the most tax-advantaged accounts. Here are some key steps to consider:
Understand Account Types
Taxable Accounts include brokerage accounts where you pay taxes on dividends, interest, and capital gains annually.
Tax-Deferred Accounts include traditional IRAs and 401(k)s, which allow taxes to be deferred until withdrawal.
Tax-Exempt Accounts are Roth IRAs and Roth 401(k)s, where contributions are made with after-tax dollars. Still, withdrawals are tax-free if certain conditions are met.
Match Investments to Accounts
Tax-Efficient Investments include stocks and equity funds, which benefit from lower capital gains taxes. These are best held in taxable accounts.
Tax-Inefficient Investments include bonds, REITs, and actively managed funds that generate regular taxable income. These should be placed in tax-deferred or tax-exempt accounts to shelter their income from annual taxes.
Consider Your Investment Horizon
Long-Term Investments are investments you plan to hold for over a year, such as growth stocks, that can be placed in taxable accounts to take advantage of long-term capital gains rates.
Short-Term Investments are investments that you plan to hold for less than a year and should be placed in tax-advantaged accounts to avoid higher short-term capital gains taxes.
Regularly Review and Adjust
Rebalance by periodically reviewing your asset location strategy to ensure it aligns with your financial goals and any changes in tax laws.
Tax-Loss Harvesting can be done in your taxable accounts. Consider selling underperforming investments to offset gains and reduce your tax liability.
Placing your investments in the proper accounts could reduce your tax liability and enhance your after-tax returns. Consulting with a financial advisor can provide personalized guidance if you have specific financial goals or a complex portfolio.
Chris graduated from the University of Maine, where he played hockey on a scholarship, and retired from professional hockey in 2007. In the community, he remains engaged, serving as a youth hockey coach. Chris holds the CERTIFIED FINANCIAL PLANNER™. Outside the office, he enjoys trying new food and wine, reading, traveling, playing golf and hockey, fat tire biking, and donating to local charities. His passions include being a husband and dad, lake life with the family, watching his son and daughter play sports, and spending time with his wife. To learn more about Chris, connect with him on LinkedIn.
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References
The Vanguard Group, Inc. (2020, June). Putting a value on your value: Quantifying Vanguard Adviser’s Alpha [Review of Putting a value on your value: Quantifying Vanguard Adviser’s Alpha]. https://www.ch.vanguard/content/dam/intl/europe/documents/en/putting-a-value-on-your-value-quantifying-vanguard-adviser-alpha-eu-en-pro.pdf