Why Does Asset Location Matter for Tax-Efficient Investing?

When creating a portfolio, investors take several factors into consideration such as risk, asset class, returns, etc. However, more often than not, they forget to account for two critical factors – asset location and taxes. Both these factors are interlinked and, if not planned efficiently, can result in you having to pay more in taxes.

Different asset classes have different taxation rules, and thus, require careful planning. Asset location is an important factor that will significantly influence your asset allocation and tax planning. If you want to understand the relationship between asset location and taxes, do reach out to a professional financial advisor who can guide you on the same.

In this article, we answer all your questions as we dive deep into asset location and its importance in tax planning.

What is the difference between asset allocation and asset location?

Many individuals confuse asset location with asset allocation or use them interchangeably.

But, asset location and asset allocation are different concepts, and it is crucial to understand how one is different from the other. While asset location is the account where you put your money, asset allocation broadly refers to a selection of assets, spread across class and sector (to form a portfolio).

The best location for a particular asset depends upon factors like financial profile, existing policy and laws, the duration of holding, and, most importantly – taxes.

Read further to know the different types of asset locations and their importance from a tax perspective.

What are the different types of asset locations for effective tax management?

While risk is a crucial factor to keep in mind when allocating or choosing an asset, you should have a plan for how you are going to handle your taxes. This can be done through asset location. A few asset locations for effective tax management are mentioned below.

1. Tax-advantaged accounts

Tax-deferred or tax-advantaged accounts offer you a means to invest without paying the taxes right away. Investing money into these accounts is one of the most common practices of tax-efficient investing. These include 401(k)s, SEPs, IRAs (with traditional rules), etc.

2. Tax-free accounts

Tax-free accounts allow you to make an investment with your post-tax income. This essentially means that you pay the taxes on your income and then invest in these securities. Any income subsequently generated through these accounts is not taxed. The difference between a tax-advantaged and a tax-free account is that your taxes get deferred in the former, and there are no taxes applicable in the case of the latter.

Note: The IRS has instated a limit on the amount you can invest and place under tax-free accounts.

3. Taxable accounts

Taxable accounts are also known as brokerage accounts. Taxes apply to the gains you make on investments that are placed under these accounts. For example, dividends and capital gains will be taxed if earned from an investment placed in a taxable account.

Now, you will need to carefully decide your asset location based on the kind of tax treatment you want to receive.

What is the importance of asset location?

Asset location plays a significant role in tax-efficient investing.

Firstly, asset location aids the creation of a diverse portfolio. Using the basics of asset location, you can place your money in tax-advantaged or tax-free accounts. Secondly, asset location is vital from a taxation point of view. Ideally, you should be taking advantage of those investments that come with tax benefits to save money which otherwise you would be paying as taxes. For instance, if you have high-earning investments in your portfolio, the income generated from these investments can be used to set off the taxes levied on investments placed in taxable accounts. Doing so, you can use both asset allocation and location strategically to manage your taxes.

Let us read the factors that affect asset location in detail below.

What are the factors that affect the asset location?

Asset location is paramount to ensure your returns are not diluted due to taxes. For tax-efficient investing, you need to consider a few factors and then decide on asset location.

These factors include:

1. Eligibility for tax-deferred accounts

You cannot place all your investments in a tax-deferred account. For instance, collectibles cannot be a part of IRAs. Additionally, there are restrictions on different kinds of precious metals like gold, platinum, etc.

2. Taxes on interest

Interest is considered to be an ordinary income, and hence, it attracts regular taxes. There are some exceptions, like municipal bond income, but usually, taxes are levied on them.

3. Taxes on capital gains

A capital gain gets credited to your account when you sell off or exchange security at a higher value than what you paid while purchasing it. Generally, short-term capital gains are taxed at a regular rate that can go up to 37%. However, in the case of long-term capital gains, the tax rate is comparatively lower than the ordinary tax rate. You earn long-term capital gains when you hold an investment for more than a year and sell or exchange it.

4. Taxes on capital losses

A capital loss is when you sell an asset or security at a lower price than what you paid to purchase it. Your profit and losses are accounted for together to find out if you earned a net gain or incurred a net loss. An annual deduction of $3000 is applicable if losses exceed the gains.

5. Taxes on dividends

Dividends are taxed in a way that is similar to long-term capital gains. A dividend only becomes qualified when paid by a US company or an established foreign company. If you are earning dividends from a tax-exempt organisation, the dividends will be taxed at an ordinary rate.

6. Saving bonds

Saving bonds are securities with low investment limits so that anyone can invest in these bonds easily. Here, the owners of such a bond can defer the taxes to a point where they finally cash in the bond or transfer it to someone else.

7. Tax-exempt status

These include any earned income that is free from any taxes. Some retirement accounts, like Roth 401(k), etc., are tax-free accounts, as you contribute post-tax income in such accounts.

8. Municipal bonds

Municipal bonds are securities that are issued by the state and federal governments. When you invest in municipal bonds, you don’t need to pay any taxes on them.

9. Health savings accounts (HSAs)

HSAs allow you to make tax-deductible contributions. You can also take tax-free withdrawals from this account. 

How to minimise taxes with asset location

The location of the asset or the investment will define how it will be taxed.

Let us take capital gains, for example. Based on your income level, long-term capital gains have an applicable rate of 0%, 15%, or 20%. Now, equity investments fetch money both in the form of dividends and capital gains, and hence, if placed in a taxable account, they may reduce your tax bill. However, if you place this money in accounts where you can only withdraw your money post-retirement, these gains will be taxed at an ordinary rate that can go as high as 37%.

Interest income can be another example. The interest you earn (from bonds etc.) is taxable and is charged with an ordinary income rate between 10% and 37%. Similarly, different incomes and assets from different locations trigger disparate ranges of taxes.

As an investor, you must critically analyse asset locations, allocations, and taxes to make the best of your investments and avoid footing a large tax bill.

To summarise

For tax-efficient investing, you must be mindful of both asset location and asset allocation. You need to have a balanced tax strategy if you want to benefit from asset location. Understand carefully the taxes that each asset class attracts. Ensure that you have distributed your funds in different asset locations to derive the benefits of each location. Consult a financial advisor or a tax expert to seamlessly navigate taxes, asset allocation, and investment planning.

Use the free advisor match tool to match with an experienced and certified financial advisor who will be able to guide you effectively on asset allocation, planning, and taxes. Give us basic details about yourself, and the match service will connect you with 1-3 professional financial fiduciaries that may be suited to help you.

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