Many people track their investment returns. They want to know how their accounts are doing, specifically, how much did their accounts grow both in percentage and dollar amounts. While it is good to track investment returns, very few consider their after-tax returns, even though taxes can have a huge impact on the actual return. After all, it is not what you earn, but what you get to keep, that is most important.
One way of minimizing taxes with your investments is by using an asset location strategy. Different investments, such as stocks, bonds, and limited partnerships are taxed differently. Some investments produce capital gains and qualified dividends, which are taxed at a maximum tax rate of 20%. Other investments produce ordinary income which can be taxed as high as 39.6%. Different types of accounts, such as IRA accounts, Roth accounts, annuities, or non-retirement accounts also have different tax treatment. You can minimize taxes by thoughtfully matching the investment with the account type.
Some investments are tax-efficient in that they generate little to no taxable income each year. The return comes mainly from price appreciation which is taxed only upon sale of the investment. Individual stocks are an example of a tax-efficient investment. Say you purchase a stock for $10,000, hold it for five years, then sell it for $15,000. In the year that it is sold, you have a realized taxable gain of $5,000. This gain is taxed at a capital gains rate, which is a lower tax rate than what you pay on ordinary income, such as your salary.
Other investments, such as taxable bonds, are considered tax-inefficient. The return is paid in the form of monthly interest, which is taxable each year at ordinary income rates.
Mutual funds can be either tax-efficient or tax-inefficient, depending on a number of factors.
Asset location involves positioning the tax-efficient investments in account types that are taxed each year, and positioning tax-inefficient investments in account types that grow tax-deferred (IRA accounts) or tax-free (Roth accounts).
To illustrate with a simple example: You want to buy Microsoft stock in your portfolio. You have both an individual (non-retirement) account and an IRA account. In which account should you purchase the stock?
If you buy in the individual account, you will pay tax each year on the quarterly dividends. However, qualified dividends enjoy a lower, favorable tax rate. If the stock does well, you will pay tax on the gain upon the sale of the stock. The gain will also be taxed at the lower capital gains rate. If the stock does poorly and loses money, you can sell the stock and take a tax loss to offset some of your other gains.
If you decide to buy the Microsoft stock in your IRA account, you will not need to pay tax on the quarterly dividends each year as this is a tax-deferred account. However, when you eventually withdraw the gains from the IRA, you will pay tax at the ordinary income rate. You are swapping lower tax rates (capital gains and qualified dividend rates) for higher tax rates (ordinary income rates). Also, if the stock loses money, you cannot write off any of the loss. Therefore, it makes more sense to hold the stock in your non-retirement account.
There are many factors to be considered with asset location. It involves understanding and researching the tax-efficiency of each investment. It is underutilized, even by financial advisors, because it involves a thoughtful, time-consuming approach with the results not being easily discernable. Over time however, the tax savings can be significant, especially for long-term investors who are in higher tax brackets.