Minimize taxes using asset location – Carswellfamilyfoundation

What is the location of the asset?

Asset allocation is a tax minimization strategy that helps investors optimize their portfolio by taking into account the tax treatment of different types of assets. investments. Investors can maximize their after-tax returns by placing certain securities in either deferred tax or taxable accounts. But how does asset allocation minimize taxes, and how can you apply this strategy to your own investments?

Key Findings

Balanced portfolios that include both equity and fixed income investments will benefit the most from asset allocation.
Older investors or those approaching retirement may benefit from greater tax benefits from asset location, especially if they plan to start withdrawing funds soon.
Stocks and equity funds are best held in taxable accounts to take advantage of lower capital gains taxes.
The benefits may be less pronounced for younger investors, but the right asset allocation can still boost long-term returns.

Achieving optimal asset placement

While asset allocation is a powerful tax strategy, it should be considered as a complement to asset allocation— the process of distributing investments (shares, funds, other holdings) across various sectors in order to reduce risk. Only after determining the proper asset allocation for your portfolio should you consider the tax benefits of each investment.

The best place to place an investor’s assets depends on factors such as your financial profile, tax laws, and investments. holding periodsand tax characteristics of individual securities.

Tax-friendly stocks should be held in taxable accounts due to lower capital gains, dividend tax rates, and the ability to defer gains. Riskier and more volatile investments qualify for a taxable account both because of the potential for tax deferral and the ability to lock in tax losses on underperforming investments sold at low prices. recognized loss.

Index funds and Exchange Traded Funds (ETFs)valued for their tax efficiency and should also be held in taxable accounts, just like tax-free or tax-deferred bonds. Taxable bonds, real estate investment trusts (REIT) and related mutual funds should be held in tax-deferred accounts to avoid higher ordinary income tax rates on interest and dividend payments.

Who benefits from asset location?

You need to invest in taxable and tax-deferred accounts to take full advantage of asset location. Typically investors with balanced investment strategy Investments consisting of both equities (stocks) and fixed income (bonds) may provide the greatest benefits. While investors investing only in equities or fixed income can still benefit, the benefits are more pronounced in a balanced strategy.

A typical investor with a balanced portfolio (for example, 60% stocks and 40% bonds) may hold different types of assets in taxable and tax-deferred accounts. For example, stocks or equity funds are best placed in taxable accounts, while fixed income investments should be placed in tax-deferred accounts, e.g. IRA or 401(k).

Asset allocation for a balanced portfolio

Let’s consider an investor whose portfolio is 60% equities and 40% fixed income. The goal is to position assets to minimize taxes while maintaining the same overall asset allocation:

Tax-deferred accounts (such as an IRA or 401(k)): Keep 40% of fixed-income investments (such as bonds) in these accounts, since bond interest is taxed at ordinary income rates.
Taxable Accounts: Hold 60% in stocks (e.g. stocks, stock mutual funds) here. long term capital gains and qualified dividends are taxed at preferential rates (0%, 15% or 20%).

This strategy ensures that taxable bond income is deferred and taxed at a lower rate, while more tax-efficient stock income is taxed at preferential rates.

If an investor is withdrawing funds from tax-deferred accounts or will be doing so soon, the benefit from asset location is greater than for younger investors who have many years left before they start withdrawing funds.

Let’s say an investor has saved $20,000 in capital gains and dividends from a traditional individual retirement account (IRA). The investor takes the total amount as a distribution, which is then treated as ordinary income. If the taxpayer falls into the 35% tax bracket, the investor would be left with $13,000. If an investor had earned $20,000 in long-term capital gains and qualified dividends in a taxable account, the tax would only be 15%, leaving $17,000 remaining.

How a security is taxed will determine where it should be held.

How asset allocation minimizes taxes

How a security is taxed will determine where it should be held. Long-term capital gains and qualified dividends have favorable rates of 0%, 15% or 20%, depending on your income level. In this case, taxable interest is reflected Form 1040 and is subject to ordinary income rates ranging from 12% to 35%.

Since most equity investments generate income in the form of both dividends and capital gains, investors receive lower tax bills when owning stocks or fractional shares. mutual funds within a taxable account. However, those same capital gains and dividends will be taxed at regular rates (up to 37%) if withdrawn from a traditional IRA, 401(k), 403(b)or another type of retirement account in which taxes are due when withdrawals are made.

Fixed income investments, such as bonds, generate regular cash flow. These interest payments are subject to the same ordinary income tax rates, up to 37%.

What is the difference between asset allocation and asset allocation?

Asset allocation refers to how you divide your investments across different asset classes (stocks, bonds, real estate, etc.) to balance risk and return. Asset allocation is a strategy for placing those investments in the right type of accounts (taxable or tax-deferred) to minimize taxes. Although asset allocation focuses on diversification and risk managementAsset allocation is a tax-efficient strategy that helps you retain more of your profits by reducing your tax burden.

How can I determine which investments are best suited for taxable accounts versus tax-deferred accounts?

Tax-efficient investments, such as stocks (especially those with qualified dividends) and index funds, should be held in taxable accounts, where they benefit from lower capital gains and dividend tax rates. Bonds, taxable mutual funds and REITs (which often generate high taxable income) are better suited to tax-deferred accounts like an IRA or 401(k), where the tax burden is deferred until the funds are withdrawn.

How does asset allocation affect my retirement planning?

Asset location plays a critical role in retirement planning because it helps minimize the taxes you’ll pay on investment earnings over the long term. For example, you can maximize the tax benefits of tax-deferred accounts such as IRAs and 401(k)s by holding investments in those accounts that generate taxable income (such as bonds). This allows you to save more wealth for retirement. Plus, strategically placing tax-efficient assets in taxable accounts means you can take advantage of lower tax rates on long-term earnings and dividends in retirement.

Bottom line

Asset allocation is a strategy that aims to maximize after-tax returns by placing investments in accounts that provide the most favorable tax treatment. The key to effective asset allocation is understanding your financial profile, tax situation and investment time horizon. By carefully considering where to place your taxable and tax-deferred investments, you can potentially lower your overall investment amount. tax liability and enhance the long-term growth of your portfolio.