Learn about asset location, how it can help you minimize taxes, and how to find the optimal strategy for you.
Learn about asset location, how it can help you minimize taxes, and how to find the optimal strategy for you.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
Have a money question? Send an email to money@quickanddirtytips.com or leave a voicemail at 302-365-0308.
Find Money Girl on Facebook and Twitter, or subscribe to the newsletter for more personal finance tips.
Money Girl is a part of Quick and Dirty Tips.
Links:
https://www.quickanddirtytips.com/
https://www.quickanddirtytips.com/money-girl-newsletter
https://www.facebook.com/MoneyGirlQDT
https://twitter.com/LauraAdams
If you're an investor or want to be one, you've probably heard that you need the right asset allocation, which is the right mix of stocks, bonds, and cash, to achieve your financial goals. That gives you the proper investment growth and income based on your risk tolerance and the period you expect to own your investments.
However, a powerful and often-overlooked aspect of investing is where you should own your assets, known as asset location. This post will explain asset location, how it helps you minimize taxes, and how to find the optimal location strategy.
Hi, friends, and thanks for joining me this week! I'm Laura Adams, an author, media spokesperson, and money speaker hosting the Money Girl podcast since 2008, with over 42 million downloads.
I'm also the founder of The Money Stack, a weekly newsletter and community helping you build your bank account on your terms. It includes each week's podcast, money tips, tools, things I enjoy, and invitations to Live Educational Events and their video replays. So, I'd love you to sign up for free at LauraDAdams.com!
If you're not already subscribed to the podcast, that's the best way to ensure you never miss a weekly episode. I always love getting your money questions and comments–you can leave them on our voicemail line at 302-364-0308. You can also send me an email using my contact page at LauraDAdams.com.
What is your investment portfolio asset location?
Your asset location is how you divide up investments in your portfolio among various accounts based on how they'll get taxed. It's a strategy for taking advantage of the fact that different accounts tax you differently, and investments are subject to different taxes.
For instance, you may own some investments in a taxable brokerage account, where earnings like interest, dividends, and distributed capital gains are taxed annually. I'll review those taxes in more detail shortly.
You might own investments in a tax-deferred traditional retirement account, like a 401(k) or IRA. These accounts shelter pre-tax contributions until you take withdrawals in retirement, which are then taxed as ordinary income.
You might also choose a tax-free account, like a Roth IRA, if you qualify for one. These accounts allow after-tax contributions to grow and be withdrawn tax-free.
Since different accounts and investments have different tax rules, correctly matching them can save a considerable amount of taxes, which is why considering asset location is essential. I'll give you some specific examples in a moment.
ALSO READ: Is it better to have a traditional IRA or Roth IRA?
How are investments taxed in a brokerage account?
First, to fully understand asset location, it helps to know how investments get taxed. I'll give you a brief overview.
There are two situations when taxes apply to your investments in a taxable brokerage account. The first is when you receive income, such as interest or a dividend, added to your account. The second is when you sell an investment for a gain, known as a capital gain.
In the first scenario, interest and dividend income is generally taxed at your ordinary income tax rate. Ordinary taxes apply to all income, including wages, salaries, bonuses, commissions, tips, and royalties. For 2024, the rates range from 10% to 37%, depending on your total taxable income for the year.
In the second scenario, a gain from selling an investment for a profit gets taxed either as a short-term or a long-term capital gain. The short-term capital gains tax applies if you own a capital asset for a year or less, and it's exactly the same as ordinary income tax rates.
Long-term capital gains apply if you own a capital asset for more than a year. They're favorable because they're lower than ordinary income tax rates, ranging from zero to 20%. That encourages investors to hold investments for the long term.
Note that certain investments have higher capital gains tax rates. For instance, collectibles, such as coins, rare stamps, and art, typically have a long-term capital gains tax rate of 28%. Plus, if you have a high income, you may be subject to the net investment income tax, an additional 3.8% tax added to the capital gains tax. However, you can offset capital gains with any capital losses up to a limit, helping reduce your tax liability.
Other taxes may apply to certain investments, such as municipal bonds. They're usually tax-free for federal income taxes but may be taxable by your state, depending on the state that issued the bond and where you live.
The takeaway is that not all taxes are equal. Generally, taxes on ordinary income and short-term capital gains are higher than taxes on long-term capital gains.
ALSO READ: 6 things to know before investing in a brokerage account
How are investments taxed in a retirement account?
As I previously mentioned, and as you likely know, owning investments in a retirement account changes the tax rules. Retirement accounts are so great because they reduce your tax liability.
Traditional accounts (like a traditional 401(k) or IRA) allow you to claim a tax deduction for contributions. Your investments grow tax-deferred until you withdraw amounts and then pay ordinary income taxes in retirement.
The other primary type of retirement account is a Roth (like a Roth 401(k) or Roth IRA if you qualify for one). They don't allow a tax deduction on contributions but allow tax-free investment growth and tax-free withdrawals in retirement.
RELATED: How many retirement accounts can you have?
How does asset location minimize taxes?
Now that you understand how investments get taxed in brokerage, traditional, and Roth accounts, how do you create an optimal asset location to minimize your taxes? Well, it depends on the types of investments you own.
For instance, let's say you own bonds. They pay interest and get taxed at ordinary income tax rates, which could be as high as 37%, plus a 3.8% surcharge, depending on your income. So, locating bonds in a tax-sheltered account like a traditional or Roth retirement account is smart.
Other investments to consider locating in tax-deferred or tax-free accounts include real estate investment trusts (REITs), mutual funds, and CDs. When possible, investments with relatively high tax rates are best positioned in tax-advantaged accounts.
The opposite is true with a taxable brokerage account, where you want to own investments with relatively low tax rates or tax-efficient ones, like tax-free bonds, index funds, and exchange-traded funds (ETFs).
If you own stocks, you decide when to sell them and create a capital gain or loss. As I mentioned, the long-term capital gains tax is favorable because it only goes up to 20% if you hold them for over a year. But selling stocks after a year or less means paying higher short-term gain rates.
So, investments with high taxes are best for tax-advantaged accounts, and those with relatively low taxes are best suited for taxable brokerage accounts.
RELATED: 7 pros and cons of investing in a 401(k) retirement plan
Who benefits from optimal asset location?
As with all tax strategies, your income and tax bracket impacts your potential savings. Asset location is most beneficial if you're in a high tax bracket and have the three types of accounts I've covered: taxable, traditional, and Roth. After all, if you only have a taxable brokerage account, you can't do any relocating
Consider a typical investor who owns 70% stocks and 30% bonds spread evenly between their brokerage account and traditional 401(k). If they have the same asset allocation in each account, they have poor asset location. A better strategy would be owning all their bonds in their tax-deferred traditional 401(k) and all the stocks in their taxable brokerage.
Remember that bonds pay interest, which is subject to higher ordinary income tax rates. Stocks, if you own them for more than a year, are subject to lower long-term capital gains tax rates when you sell them.
When it comes to cutting taxes, you can't beat a Roth account because investment growth and withdrawals are entirely tax-free–but not everyone has access to a Roth. If you're fortunate enough to have a workplace Roth, like a Roth 401(k) or 403(b), you can participate no matter your income. However, with a Roth IRA, high earners don't qualify if they exceed an annual income limit.
Locating investments in the right places is more art than science because it depends on the investor's financial situation, assets, investment holding periods, and tax laws.
Sometimes, you might go against the grain of good asset location by keeping high-taxed investments in a taxable account so you can sell them anytime.
Remember that taking distributions from a retirement account before age 59.5 means paying ordinary income taxes on amounts not previously taxed plus an additional 10% early withdrawal penalty
To sum up, taxes are only one consideration for investors; however, there are some smart strategies that help you avoid paying more than you should. The less you pay in taxes, the more you can keep invested and working toward your goals.
If you're enjoying Money Girl, please rate and review the show in your podcast app to let us know you're getting value from each weekly episode!
That's all for now. I'll talk to you next week. Until then, here's to living a richer life. Money Girl is a Quick and Dirty Tips podcast. It's audio-engineered by Steve Rickeberg. Our Director of Podcasts is Brannan Goetschius, our digital operations specialist is Holly Hutchings, our advertising operation specialist is Morgan Christianson, our marketing and publicity associate is Davina Tomlin, and our marketing assistant is Kamryn Lacey.