Diversification and asset allocation are important components to any investment plan. Additionally, where assets such as stocks and bonds are held, also called asset location, should also be considered.
Asset location refers to the type of account that asset classes are held. Such accounts are generally traditional and Roth IRAs, employer-sponsored plans such as 401ks, etc., and after-tax, non-qualified investment accounts.
The reason asset location becomes important is to help make use of tax efficiency in an investment portfolio. For example, stocks held in after-tax, non-qualified accounts for longer than one year as well as qualified dividends are taxed at much more favorable rates. These favorable rates can range from as little as zero to 20%. Bond interest, however, is taxed as ordinary income, leaving an investor being taxed at potentially higher amount.
As many readers know, amounts contributed to qualified, pre-tax accounts such as deductible IRAs, 401ks, etc., are taxed as ordinary income when withdrawn from the respective plans. Even non-deductible IRAs have their earnings taxed as ordinary income when withdrawn. Designated Roth accounts and Roth IRAs are funded with after-tax contributions and qualified withdrawals are tax free.
In a perfect world, an investor would want to hold their stocks in an after-tax, non-qualified account. This way they could take advantage of the more favorable long-term capital gains and dividend rates. Also, this investor would want to hold their bonds in a tax-deferred account such as a 401k or IRA or Roth IRA.
Alas, it’s not a perfect world! For many individuals, their main savings are going to be in the form of employer-sponsored plans and IRAs. Tax efficiency for stocks does start to make a lot more sense for higher net worth individuals that have additional investments in non-qualified accounts.
However, some individuals may be able to get similar tax efficiency for stocks by investing in Roth designated accounts and Roth IRAs should they be in lower tax brackets. In other words, by contributing to Roth accounts, they’re taxed on the contributions now, and any appreciation and dividends are received tax free in retirement – when they may potentially be in a higher tax bracket.
For bond holdings, it makes perfect sense to hold these assets (and their interest income which is taxed at ordinary rates) in qualified accounts and even Roth accounts. One caveat, however, is municipal bonds. Generally, these should not be held in qualifying accounts as their interest is already exempt from federal taxation.
If you have questions regarding your asset location, feel free to contact us at your convenience.
Sterling Raskie, MSFS, CFP®, ChFC®
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