Make Your Investments Tax-Efficient by Using the Asset Location Strategy
By Todd I. Youngdahl, CFP®
When it comes to investing, it’s not just what you earn, but what you keep after taxes that matters most. Between federal income, capital gains, alternative minimum tax, and state and local taxes, your earnings can take quite a hit. Tax-efficient investing is crucial to building wealth, especially if you are in the higher tax brackets.
One of the best ways to approach tax-efficient investing is to use a smart asset location strategy. With tax season in full swing, here is a guide to tax-efficient asset location and the best tax strategies to consider when investing.
Asset Location is the strategy of choosing particular investments based on the type of investment account you hold.
There are three main types of investment accounts:
1. Tax-deferred accounts: Accounts that allow contributions to be deducted from current income, meaning they are not taxed when added to the account, but all earnings and future distributions will be taxed. Think traditional IRAs, 401(k)s, 403(b)s, and annuities.
2. Tax-exempt accounts: These accounts require taxes to be paid up front on all contributions, but all earnings and future distributions are received income-tax-free. Examples include Roth IRAs, Roth 401(k)s, and Roth 403(b) accounts.
3. Taxable accounts: These are traditional brokerage accounts that allow you to invest in a wide array of investment offerings. They do not have any tax advantages and thus require the most strategy when choosing which investments to use. Any money contributed will be on an after-tax basis, and any subsequent interest or dividends earned will be taxed. You will also be taxed on capital gains if you sell an investment for a gain.
Asset Location Strategy is most useful for taxable accounts since they do not offer any tax advantages on their own. By coordinating your investments to match the tax characteristics of a particular investment account, you can make the most of your money by minimizing your overall tax liability.
There are several tax-efficient investments to include in a taxable account, including:
Municipal bonds are issued by state and local governments and the interest income earned is exempt from federal income tax. This makes them particularly useful for high-income earners who want to invest in tax-advantaged assets. In addition to federal income tax exemption, many states offer state tax exemptions if you buy a bond from the state in which you reside. These bonds won’t provide the highest yield, but they are one of the most tax-efficient options available.
By holding municipal bonds in your taxable accounts, you are maximizing your position since they are tax-free on their own. If you were to hold a municipal bond in a tax-sheltered account like a Roth IRA, you would effectively be wasting the tax-free nature of the investment itself.
Exchange-traded funds (ETFs) are similar to mutual funds in that they invest in several different underlying assets that track an index or a sector of the economy. They are more tax-efficient than mutual funds due to their passive management style and low turnover rates.
Mutual funds are actively managed and seek to outperform the broader market indices. Because of this investment strategy, there are usually high rates of turnover of the underlying securities that make up the fund as the portfolio manager seeks to time the market and earn returns by “buying high and selling low.” With each transaction completed, there are tax consequences that get passed through to the owner of the mutual fund shares. Most often these come in the form of short-term capital gains, which are taxed as ordinary income at your marginal tax rate.
ETFs have significantly less turnover due to the passive nature of the investment. They follow a “buy and hold” strategy and are therefore much more tax-efficient, which makes ETFs a great option for taxable investment accounts.
Individual stocks can be tax-efficient when bought and held for at least one year. This gives the stock a long-term holding period, allowing it to be taxed at the preferential long-term capital gain rate when sold.
Individual securities also provide a number of other tax-saving strategies, including:
- Tax-loss harvesting: Selling investments at a loss in order to offset the gains in a portfolio. By realizing a capital loss, the taxes owed on capital gains can be counterbalanced. If losses exceed gains, they can be deducted from ordinary income up to $3,000 per year.
- Timing of capital gains: This involves timing the sale of appreciated investments to correspond with a year in which income is lower, allowing gains to be taxed in a lower tax bracket.
These tax strategies should generally only be used in taxable accounts, since you won’t be able to deduct the losses from income if they are held in a tax-sheltered account.
Are you making the most of your taxable investment accounts? At Washington Wealth Advisors, we can help you make the most of a smart asset location strategy and minimize your taxes along the way. If you would like to learn more about how we can help, call our office at 703.584.2700 or email firstname.lastname@example.org or click here to schedule some time with your advisor.
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