This article originally appeared in Aldrich Wealth’s 2019 Q3 Beyond the Benchmark. To view the full suite of our quarterly market commentary and newsletter, click here.
Selecting the most appropriate asset allocation provides the best opportunity to achieve your long term goals, but the implementation of that allocation is also critical. You could invest each of your accounts the same way, or you could strategically place each asset class in the most tax-efficient account. This decision involves selecting which account(s) will hold equities and which will hold fixed income. The placement of assets can have a significant impact on your after-tax investment return and ultimately extend the longevity of your portfolio.
There are two basic types of investment accounts: taxable (such as individual, joint and trust accounts) and tax-deferred (such as 401(k) and IRA accounts). The taxation of interest, dividends, and capital gains is different between these types of accounts. Understanding the difference can minimize your tax burden and increase your return. In a taxable account, income is taxed in the year it is received, regardless of whether the income is withdrawn from the account. If assets have appreciated and are then sold, you would pay capital gains tax in the year the asset was liquidated. For many investors, the preferential tax rate for qualified dividends and capital gains is lower than their ordinary income tax rate, but it does result in taxes due each year. However, withdrawing money from a taxable account does not result in taxation.
Tax-deferred accounts allow you to avoid annual taxation on income and capital gains. This can be beneficial during the accumulation years when you are likely earning a higher income and are in a higher tax bracket. However, when you take withdrawals from those accounts in the future, the entire withdrawal is taxed as ordinary income. There is no preferential treatment for dividends or capital gains, as there would be in a taxable account. At age 70 ½, you are also required to start taking annual distributions from these tax-deferred accounts. If this required distribution is large, it could cause a significant increase in tax liability.
If you have both account types, it is typically more tax-efficient to hold income-producing securities (bonds and dividend-paying stocks) in your tax-deferred accounts, while using taxable accounts for the assets with the best opportunity to grow. This strategy can help defer current taxation on the interest income and focuses the taxable portfolio on growth-oriented assets that are subject to the advantageous long term capital gains rates. The asset location decision ultimately depends on your overall investment allocation and the amount of money you have in taxable and tax-deferred accounts.
In some cases, a Roth IRA is also a viable option. Unlike traditional tax-deferred IRAs, contributions to a Roth are made with after-tax funds. Annual income and capital gains are not taxed, and all withdrawals are tax-free (assuming you’re over 59 ½ and have held the Roth for over five years). If you are projected to be in a high tax bracket when you take withdrawals or do not want the requirement of taking distributions at age 70 ½, a Roth may be a good option.
It is crucial to consider your investment portfolio holistically to maximize the after-tax return of your portfolio. Rather than implementing the same allocation in each account, it is more efficient to view the accounts in aggregate and manage them on a consolidated basis. This strategy reduces costs associated with purchasing the same investment in multiple accounts and provides you with the most tax-efficient portfolio. Though every investor’s situation is unique, the ultimate goal remains the same – to maximize the portfolio’s after-tax return.
Senior Financial Planner, Wealth Manager
Kayla Cook, CFP®
Kayla joined the firm in 2014. She has many years of experience working in the areas of personal finance, financial planning, and investments. Kayla is responsible for analyzing a client’s financial information and determining the best approach for meeting their objectives. In addition, Kayla provides strategic wealth management for individuals, families, and organizations. She is…
- CERTIFIED FINANCIAL PLANNER™
- Series 7 and Series 63 security exams
- Personal finance, financial planning and investments
- High-net worth individuals