Note: This post was inspired by a December 2023 article by Fidelity on asset placement as a tool for tax-efficiency. I hope to build on those broad themes here with my own views.
Asset placement, – which can be described as the purposeful allocation of a specific investment or asset class into a specific type of account as distinguished by tax classification in order to maximize tax-efficiency, – is an often overlooked part of investment management and estate planning. Perhaps because investment return reports are illustrated on a gross of tax basis, while tax-inefficiencies are evident only on the investor’s tax return, little thought seems to be given as to how a portfolio that encompasses not only various asset classes but also accounts with differing tax classifications can be organized in such a way that frictional costs such as taxes can be reduced as much as possible.
Before getting into specific examples, let us assume for the sake of this post that there are three basic types of accounts by tax classification: a “non-qualified” or taxable brokerage account funded by after-tax monies; a tax-deferred account such as a traditional IRA, a SEP IRA, a 401(k), 403(b), etc., funded by pre-tax contributions; and a tax-free Roth IRA or Roth 401(k) funded by after-tax contributions, but in which the earnings and distributions are both tax-free. As it relates to asset placement, the tax classification of each type of account will have a huge impact on how it should be utilized to maximize after-tax returns for a given asset allocation because the tax code treats various asset classes differently when it comes to tax rates.
For example, growth stocks, if held for greater than one year in a taxable account, might be subject to more favorable long-term capital gains rates, In some cases, long-term capital gains may not even be taxable at all. Qualified dividends are treated similarly. Conversely, however, distributions from REITs are taxed at ordinary income tax rates, making them ill-suited for ownership within a taxable account. On the fixed income side, interest paid on Treasury bills, notes, and bonds are federally taxable, but state income tax exempt, while interest earned from holding municipal bonds is income tax exempt federally, but is taxable at the state level if it is from an entity outside your state of residence.
Another reason why an asset class such as growth equities are suited for a taxable account is because in such an account you start off from behind having already paid income tax on the dollars used to fund it. To compensate for this initial tax hit, an investor is better served investing after tax funds in asset classes such as growth stocks that have a higher expected rate of return. Similarly, an investor who wants to invest in some more speculative bets should consider using the taxable account for such an endeavor as the potential losses, if realized, can be deducted against gains or a portion of taxable income, whereas they are stranded within other account types.* This is especially true for Roth accounts, in which a sizable loss is effectively losing capital twice: once to taxes and again to market forces.
A notable exception for taxable accounts would be when investors are using a portion of the taxable funds for liquidity purposes, such as retirement cash flows, a down payment, and so on. In such a case, an investor might hold a portion of the taxable account in Treasurys and municipal bonds as the need for liquidity and relative safety trumps trying to maximize returns; it would obviously be less than optimal to have to access liquidity from growth investments in the midst of market downturn. I would also add that because interest received from corporate bonds is both federally and state taxable, corporate bonds are not as well suited for a taxable account unless it is a rare occasion when an investor has bought the bonds as more of a trade with the intention of realizing a capital gain as opposed to holding it for income.
As it relates to foreign stocks, holding them in a taxable account can be advantageous as taxes paid on dividends from those investments to their local governments can earn you a credit or a deduction on your U.S. tax return, but this is not available to an investor who owns the foreign shares inside a qualified account.
To summarize how I think about this, I built on Fidelity’s example, and created my own matrix of asset classes and account types based on how I think about them:
With this in mind, let us take a look at how an investor with a $1 million portfolio of 70% stocks and 30% cash & fixed income spread across a taxable account of $100,000, an IRA of $700,000, and a Roth IRA of $100,000 might use asset placement in attempt to optimize tax-efficiency while maintaining adequate liquidity:
To take this analysis a step further, suppose that the individual in the example above is approaching the age at which he or she is required to take a Required Minimum Distribution or RMD. Because he or she is required to start taking a distribution from the IRA, the immediate need for liquidity from the taxable account is relaxed, so the fixed income allocation in that account can be kept to a minimum. Furthermore, if this individual has children to whom he or she plans to leave the assets upon his or her death, then it makes sense to reduce the growth allocation within the IRA, all else equal, as not only has the investor’s time horizon compressed due to RMDs, but also current law requires, with few exceptions, non-spousal IRA beneficiaries to liquidate inherited IRAs over a period of at most ten years, whereas assets held in the taxable account benefit from a step up in cost basis, which can result in a more tax-efficient transfer of wealth. Similarly, Roth assets are inherited free of tax to beneficiaries, making them excellent estate planning vehicles. In sum, all else equal, you would want to have the most growth in a portfolio to occur in the taxable and Roth assets due to favorable legacy treatment, whereas more moderate growth might be more advantageous within IRAs and so on.
As the reader can see, there are multiple considerations and layers of complexity involved when developing not just an appropriate asset allocation but also how best to organize those assets in the most tax-efficient manner, as well as considering not just current needs but implications for beneficiaries and their own unique tax circumstances. Given these complexities, investors should consult frequently with both their financial and tax professionals to ensure their portfolios are both allocated and organized according to their ever-changing means and circumstances.
Disclaimer: Lawrence Hamtil is not a tax professional. The views expressed in this post are not to be construed as tax advice. Investors should consult with their tax professionals to see if their asset allocation is appropriate for their unique tax circumstances.
*Prior to 2018, losses in a Roth IRA could be deducted as a miscellaneous deduction if the account were closed out at less than its total contributed value, but this is no longer available given miscellaneous deductions have been phased out.
