Keeping the right assets in the right places

In reading about investing, you’ve probably seen numerous discussions of asset allocation. Probably less often, you’ve seen the term “asset location.”

This isn’t a typo. Rather, it’s the process of deciding what types of assets should be held in what types of accounts.

All too often, individual investors overlook or underestimate the importance of having a sound asset location strategy. Failure to address this critical aspect of portfolio management often means paying taxes that could easily have been avoided or deferred, and being financially hamstrung by a lack of control over taxable events. And there’s an even greater cost—reduced flexibility in investment management, leading to suboptimal long-term financial planning outcomes.

Investors owning assets in a wide range of classes and holding different types of accounts with different tax treatments have far more options for asset location. Of course, with increased options comes increased complexity.

Rules of the Road

Yet there are some basic rules of the road for all investors to keep in mind.

Taxable accounts are usually a good place to keep individual stocks, as their dividends are often qualified, which usually means a lower tax rate than from ordinary dividends, which are taxed as ordinary income, i.e., at your income tax rate. Keeping stocks in taxable accounts confers more control over withdrawals, and it saves room for higher-taxed investments in tax-deferred accounts such as the individual retirement accounts (IRAs) held by many physicians.

Taxable bonds, which are taxed at the ordinary income rate, should probably go in IRAs, or, for physicians who work as employees, in their 401(k) accounts (also tax-deferred). This also applies to REITs and many other income-yielding investments that often pay ordinary dividends.

Yet, as location philosophies vary with an individual’s investment goals and strategy, other choices may make more sense. For example, in a rapidly ascending market, an individual might want to keep some individual stocks in an IRA to defer accumulated capital gains tax stemming from frequently trading appreciated shares.

Whatever your path, the key is to maintain flexibility by owning diverse asset classes and, preferably, maintaining different types of accounts with different tax statuses. This can help investors reach their long-term investing goals without paying more tax than necessary. Moreover, this flexibility is essential for navigating ever-changing tax laws.

More Nuance

Here are some more nuanced considerations for asset location:

• Mutual funds are usually best held in a tax-deferred account because it’s nearly impossible, even for professional investors, to figure out before investing whether dividends will ordinary or qualified. This status is determined by the time period that a fund holds a given stock. For an actively traded fund, where managers frequently buy and sell stocks, it’s virtually impossible to learn or anticipate these holding periods. So, it’s best to assume ordinary dividend status and keep mutual fund shares in tax-deferred accounts, putting off tax hits from selling until after you’ve retired into a lower tax bracket.
• A notable exception is municipal bond mutual funds. Dividends from shares of funds composed purely of municipal bonds are exempt from federal tax, so keeping them in taxable accounts brings no tax pain whatsoever. Keeping them in tax-deferred accounts takes up bandwidth that should be reserved for taxable investments.
• Holding exchange-traded funds (ETFs) in taxable accounts often makes sense because this fund form’s distributions are usually more tax-favorable than those of mutual funds. ETFs often give investors what’s known as return of capital—gains received when they sell. Until then, investors generally pay less tax on dividends than they usually would on mutual funds. For investors choosing between a given investment company’s mutual funds and its ETFs with comparable holdings, the latter is usually the best choice.
• Perhaps the most egregious asset location blunder is to keep an annuity inside an IRA. Annuities should be kept in taxable accounts because their gains are already tax-deferred. If your advisor has recommended that you hold an annuity inside an IRA, you need a new advisor.
• Shares of master limited partnerships (MLPs) — an investment that’s generally done well over the past couple years in a rising energy market because many MLPs are energy-related — are usually best held in taxable accounts instead of an IRA. This is because unrelated-business taxable income from MLPs over $1,000 annually is disallowed within an IRA.
• If you don’t already have a Roth IRA, it’s a good idea to consider starting one, if possible. Roth IRAs provide tax-free access to funds in two ways: contributions can be withdrawn at any time without tax or penalty, and qualified withdrawals of growth can be made after age 59½ and after a mandatory five-year waiting period. Roth IRAs also allow flexibility in retirement because, unlike traditional IRAs, they aren’t subject to required minimum distributions (RMDs).
• Annual contributions to Roths are limited to $7,000 this year and $7,500 next year for people 50 and over, but most working physicians this age aren’t eligible to contribute one dime to a Roth because they earn too much money. Individuals with annual earned incomes of $144,000 and up (for married couples filing jointly, $214,000 and up) are disqualified.
• If you find yourself over the earnings limit, you may be able to take advantage of a loophole, commonly referred to as the back-door Roth contribution or the Roth two-step. If your onlyretirement account is a 401(k) (or a 403(b) plan) and you have no IRAs, you can make a non-deductible contribution to a traditional IRA and then, after sitting in cash for 30 days, do conversion to a Roth IRA.
• Roth IRAs can be left to heirs income-tax-free. This gives heirs of Roth IRAs an advantage over heirs of traditional IRAs. Under current tax law, non-spousal IRA beneficiaries must withdraw all funds within 10 years of the IRA account owner’s death. Whereas a Roth beneficiary can withdraw the funds without tax consequences, traditional IRA beneficiaries may be subject to various adverse tax impacts over the 10-year withdrawal period.
• A sound, forward-looking asset location strategy enables more advantageous charitable giving. Donating highly appreciated securities from taxable accounts allows you to escape taxation of appreciation and capture a charitable deduction of the fair market value of the donation. By planning donations well in advance, investors can make advantageous decisions about what assets to hold in taxable accounts.

Tail Wagging the Dog

Asset location isn’t just about tax mitigation. More importantly, it’s also about creating financial planning opportunities. However, you must be careful not to let the tax tail wag the investment dog. Even though an investment might have a more favorable tax treatment in a given type of account, it still might have lower potential for total net return than other available options.

Tax considerations should be a strong component of asset location strategies, but they aren’t the whole enchilada. To the extent that tax considerations are a priority, it’s critical to remember that tax laws are constantly changing, and your location strategy should change accordingly.

Dave Sheaff Gilreath, CFP, is a partner and chief investment officer, and Tiffany VanHook, JD, a wealth manager and vice-president, at Sheaff Brock Investment Advisors, LLC, an investment and portfolio management firm for individual investors. Gilreath is also a partner and the chief investment officer of Innovative Portfolios, LLC, an institutional money management firm. Based in Indianapolis, the two companies and their affiliated firms manage about $1.3 billion in assets nationwide.