Between the 15% capital gains tax increasing to 20% for those in the top tax bracket and the 3.8% Medicare surtax on passive investment income, some investors are shouldering an 8.8% increase in capital gains tax. And that makes tax-aware investing more important than ever.
These increases may bring asset location to the forefront. While asset allocation has always been at the core of a successful portfolio, asset location — whether to place particular investments in taxable, tax-deferred accounts or tax free accounts — often takes a back seat in portfolio construction and management.
When asset location is implemented, assets generally get divided along these lines: Tax-deferred accounts should hold investments that generate income subject to the ordinary tax rate, which can be as high as 39.6%. This includes taxable bonds and REITs to name a two. High turnover mutual funds that distribute significant capital gains would also be a candidate.
Taxable accounts should hold tax friendly equities such as ETFs or low turnover equity index funds, stocks with no or low dividends, volatile investments because of the tax advantages of harvesting portfolio losses in taxable accounts, tax-free munis, and other investments that generate long-term capital gains.
Tax free accounts should hold investments with higher expected long-term returns since ordinary income taxes and capital gains taxes are not a factor. Asset classes to consider are companies with high book-to-market ratios, small company stocks, etc.
Of course, it’s rare that asset location goes 100% by the book. For example, if you have an 80% stock and 20% bond overall asset allocation and your 401(k) is your largest account, it would have to hold more than tax inefficient bonds. And there will be location toss ups that could efficiently reside in either account. After you fill up retirement accounts first with the heavy tax investments and direct the most tax friendly investments to taxable accounts, your remaining investments can be located in either place.
Savings resulting from an astute asset location plan can be significant, especially for investors who have a sizable differential between their capital gains tax rate and their ordinary income tax rate, or those who plan on passing portfolio assets to the next generation.