Organizing Assets to Create a Tax Efficient Portfolio

Over time, investors will begin to accumulate an inventory of account types- 401(k)s, IRAs, Roth IRAs, Taxable Accounts, Annuities- the list goes on.  Additionally, the range of investment types within these accounts is sure to get more and more robust as savings increase; domestic stocks, foreign stocks, corporate bonds, municipal bonds and REITs to name a few.  And still, there will be different forms of investments such as individual stocks/bonds or mutual funds.  So how does one determine which account to hold their various investments in?  Should the high yield bond fund be held in a joint account or IRA?  What about the large cap stock fund?  Does it really matter?  The answer is yes, but…

What is Asset Location?

Asset location refers to the type of accounts in which investments are held.  An effective asset locations strategy allocates various asset classes to an appropriate account type in an effort to reduce taxes.  Broadly speaking, investors have two account types to choose from: fully taxable (also referred to as “non-qualified”) or tax favored (“qualified”). Although we cannot control tax law or market returns, we can control where investments are held.

Why is Asset Location Important?

Different asset classes have different tax implications.  For example, most dividends received from stocks are taxes at long-term capital gain rates.  Interest received from bonds on the other hand may be taxed at higher ordinary income tax rates or potentially, not at all.

Due to contribution limits set on retirement accounts, many affluent investors hold the bulk of their savings in non-retirement accounts, which are fully taxable.  Typically, these investors are usually subject to higher income tax rates as well.  Holding a tax “inefficient” asset in a taxable account can have an impact on returns over time.

The table below provides the income and applicable tax rate (as of Q1 2023) for a few common investment types.

Tax Efficient PortfolioIn addition to taxable investment income for simply holding an investment, tax may also be due upon selling an investment. Gains realized on investments held for less than one year are taxed as ordinary income tax rates compared to capital gain rates if held for a year or longer.

Let’s take a look at a couple of examples. Assume that a couple in the highest tax bracket is looking for an annual income supplement of $35k and have $1m to invest. After some quick math, the couple could conclude that a 3.5% bond from XYC Co. (company merely made up for this example) will provide the income they need. However, each dollar of interest received will be taxed as ordinary income. For this couple, that includes 37% federal tax, plus a 3.8% Medicare surtax (plus applicable state tax). Ultimately, the net income received from the bond would be just $20,720. Alternatively, the couple could purchase a 3.5% municipal bond issued in their state of residence and net all $35k in income received. The taxable equivalent rate required for the couple to net the same amount from XYC Co would be 5.91%.

Another good example can be made of mutual funds. Depending on the type, mutual fund investments may provide dividend income, interest or both. So the same considerations need to be made as with individual stocks or bonds. In addition to the type of fund, another important characteristic to consider is turnover. Turnover is the number of investments that have been replaced by the fund manager, expressed as a percentage. Simply put, if there are 100 stocks in a fund and the turnover ratio is 20%, then the manager has sold 20 stocks over the period. The higher the turnover, the greater the potential for short-term gains which are taxed at less favorable tax rates. Although turnover is not guaranteed to be the same year over year, it is a good indication of how active the fund manager is. It is more efficient to hold high turnover funds in a tax favored account.

What Is Efficient?

The illustration below reflects an effective asset location strategy.

Organizing Assets

While we acknowledge that asset location is important, we don’t want the “tax tail to wag the dog.” We believe that investment types should be selected with the primary focus on risk. Each investor will have different dollar amounts across taxable and tax-favored accounts which may not lend to a perfect asset location strategy. If the desired asset allocation can only be achieved by placing fully taxable bonds in a taxable account, we believe the benefits of proper diversification will outweigh the tax implications.

Every investor is unique and requires individual attention.  We are happy to assist your with your unique situation – please feel free to contact us at any time. 


Disclaimer: Beacon Pointe does not endorse and is not responsible for the content, product, or services of other third party sites. This article has been provided for informational purposes only and should not be considered as investment advice or as a recommendation. This material provides general information only. Beacon Pointe Advisors does not offer legal or tax advice. Private legal counsel alone may be responsible and relied upon for these purposes. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, this notice is to inform you that any tax advice included in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of avoiding any federal tax penalty or promoting, marketing, or recommending to another party any transaction or matter.

Important Disclosure: This content is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. An investor should consult with their financial professional before making any investment decisions.

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