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It's All About Location

Deciding in which accounts to hold your assets can be crucial in order to maximize after-tax returns.

As appeared in Wealth magazine

It's All About Location

Deciding in which accounts to hold your assets can be crucial in order to maximize after-tax returns.

You’re likely more than familiar with the concept of asset allocation, or dividing a portfolio into different asset classes to gain the benefits of diversification. Asset location, on the other hand, might be a little more foreign.

This strategy of efficiently distributing investment assets into accounts with different tax treatments can have as much impact on your returns as asset allocation.

Different kinds of accounts are taxed at different rates and at different times. By putting the right assets into the account that provides the best tax treatment, you can potentially boost your portfolio’s after-tax returns.

Wealth spoke with Suzanne Shier, wealth planning practice executive and chief tax strategist/tax counsel for Northern Trust, about how asset location decisions might improve portfolio returns over time.

Wealth: How do different types of investments get different tax treatments?

Shier: When we think about the types of income from a tax perspective, there are three different categories:

  1. Income that is excluded from the computation of taxable income, such as a tax-exempt municipal bond or a distribution from a Roth IRA
  2. Income subject to income tax at lower rates, such as long-term capital gains and qualified dividends that have a top 20% tax rate
  3. Income subject to ordinary income tax rates

Next, we need to think about timing – income that is subject to tax now and income that is subject to tax later. The best possible scenario from an asset location perspective is to pay the lowest possible tax rate. You do this through tax planning to align the type of asset with the type of account that will allow your investments to accumulate with the least tax consequences. That’s what we’re trying to plan toward, but you can’t always do that.

Wealth: What can investors hope to achieve with an asset location strategy?

Shier: Keep in mind the concept of triple net returns: returns after expenses, inflation and taxes. The eventual return you get on your investment is going to be affected by those factors. Inflation and expenses are not typically affected by asset location, but taxes clearly are. Overall, when you’re looking to maximize the wealth planning opportunity, you really need to look at the current and future tax treatment of all the types of accounts you could have.

Wealth: Has minimizing the tax burden become a more important goal in the last year, considering recent changes to the tax rate structure?

Shier: Yes, it’s of increased relevance when rates are higher. Beginning in 2013, we have a higher marginal ordinary income tax rate of 39.6% for the highest bracket taxpayers as well as the Medicare Contribution Tax of 3.8% (on the lesser of net investment income or modified adjusted gross income above certain threshold amounts). Taxpayers in many states also have experienced increased marginal taxes. This makes the subject that much more relevant for high-income individuals.

For those in the more modest income tax brackets, the impact of the planning may be more limited, but it can still make a meaningful difference. It makes a very big difference for high-income individuals, as our tax system seems to be making more of a distinction between high-income and other taxpayers.

Wealth: Are there risks to implementing an asset location strategy?

Shier: There is always the danger of oversimplification. For example, an IRA is tax-deferred, but that doesn’t mean all aspects of the account will be optimal from a taxable perspective.

While there is no tax on income in an IRA, distributions are taxed as ordinary income and the more favorable long-term capital gains and qualified dividend tax rates don’t apply. So, for example, you might be better off putting a stock that generates qualified dividend income in a taxable account because the dividends are taxed at the 20% rate when paid, potentially instead of the higher marginal tax rate of 39.6% at the time of withdrawal from an IRA. It’s a matter of being aware of your particular circumstances and time horizon, and that there may be a trade-off.

Also, it’s important to periodically revisit asset location strategies. What often happens is assets are acquired in a particular account, inertia sets in and they stay in that account. But tax rates or your investment objectives might change, and the strategy will need to be fine-tuned.

Suzanne Shier is the wealth planning practice executive and chief tax strategist/tax counsel for Northern Trust. She leads the wealth planning group and provides thought leadership on federal tax issues of interest to clients.