• Portfolio Strategies
  • An In-Depth Look at the Tax Consequences of Asset Location

    by Kevin Trout

    Asset location refers to where an investment asset is held: in a tax-deferred retirement account (e.g., an IRA) or in a taxable account. By fine-tuning asset location, investors can improve their aftertax return on their overall investment portfolio.

    Articles on asset location cannot definitively rank the type of investments to place in a tax-deferred account because such a ranking depends on changeable factors: return parameters that are constantly in flux in the economy; tax rates, which change with the political environment and investors’ income level; and investment holding periods, which are specific to the investor. This article summarizes the general information on asset location and gives investors access to a model that can help refine asset location decisions to take their own unique situation into account.

    Overview of Asset Location

    Investors maintaining the same asset allocation in their taxable and tax-deferred retirement accounts are not receiving maximum benefit from their tax-deferred accounts. Investors should place the investments in the tax-deferred accounts that will provide the greatest benefit. The benefit of placing an investment in a tax-deferred account can be measured by the increase in the annualized aftertax rate of return.

    ...To continue reading this article you must be an AAII member.

    Gain exclusive access to this article and all of the member benefits and investment education AAII offers.
    JOIN TODAY for just $29.
    Log in » Already a member? Login to read the rest of this article.
      
    Kevin Trout is an assistant professor of business administration and economics at Coe College where he teaches tax accounting and personal financial planning among other courses. He is a lifetime member of AAII.


    Discussion

    Gerald Lanois from FL posted over 3 years ago:

    This article is not very useful, as the Author unfortunately overlooks important details, as to the advantages/perils of other various investment types, being held in taxable, or tax defered accts, notwithstanding dividend/growth earnings!
    IE MLPS, various Prefereds, C corps, royalty trusts, CEFS, options,CDS, etc


    Bob Edds from OH posted over 3 years ago:

    Useful up to a point but much remains unsaid. Needs to include Roth IRAs. This topic begs for a great graphic that communicates what many paragraphs of text are trying to do.


    Carl Birx from NY posted over 3 years ago:

    These comparisons always make the same error in that they compare equal investment amounts. If I earn $10,000 and place it in my 401k I place all $10k in. If I earn $10k and invest it after taxes I haven't invested $10k, more like $7k after taxes. You have to take into account the taxes paid before the investment is made as well as the taxes afterwards.


    Dan from CT posted over 3 years ago:

    It would be helpful if the spreadsheet weren't protected. Not only is it protected by it also requires a password in order to remove the protection. How are you supposed to modify the tax rates to conform to your own situation?


    John Scully from CA posted over 3 years ago:

    ditto on the comments by Gerald Lanois.


    Robert Trout from IA posted over 3 years ago:

    Dan - the spreadsheet is protected so users don't inadvertantly override the formulas. But as shown in the tab "How to use the model" the cells filled with a yellow background can still be changed. So you can enter your own tax rates in the yellow cells marked "tax rate input".

    Hope that helps.

    Kevin Trout


    Robert Trout from IA posted over 3 years ago:

    Carl - If you notice in the spreadsheet the formula for the after tax rate of return includes a gross up for the tax deduction on the Traditional IRA/401k. So the model does indeed does take into consideration the deduction or exclusion of those investments vehicles.

    Kevin Trout


    David Bertholf from FL posted over 3 years ago:

    There are so many potential variables that it would be very difficult to address them all in an article of this length. I thought it did a good job as a general look. My one recommendation would be to change the title to A General Look at... vice An In-Depth Look at...


    Toan Nguyen from CA posted over 3 years ago:

    Like many retirees, I no longer work and will not have real wages in 2013. Will you please let me know the tax rates for withdrawals from IRA and dividends from stocks, assuming that my IRA withdrawal will be less than $150,000 and my dividends will total less than $80,000 for 2013. Thanks.


    Charles Rotblut from IL posted over 3 years ago:

    Hi Toan,

    The 2013 tax rates can be found here:
    http://www.aaii.com/journal/article/2012-tax-guide-update

    You will pay ordinary income tax rates on your withdrawals and the reduced dividend tax rate on qualified dividends.

    -Charles
    AAII


    M. A. from MN posted over 3 years ago:

    Bob,

    A graphic can be found in this article: www.kitces.com/blog/archives/479-Asset-Location-The-New-Wealth-Management-Value-Add-For-Optimal-Portfolio-Design.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+KitcesNerdsEyeView+%28kitces.com+%7C+Nerd%27s+Eye+View%29&utm_content=Yahoo%21+Mail

    Maud


    Mike from TX posted over 2 years ago:

    Many of these articles do not take into account the tax rate that a retiree may be in when RMD's begin. As we all know, RMD's are taxed as ordinary income. So if a person is in a high tax bracket during the RMD era many of the advantages attributed to tax-deferred assets are negated. If the tax-deferred assets are large enough you may be forced into a higher tax bracket than if you had kept the same assets in a taxable account. Any increase in returns is wiped out by the taxes due.


    Stephen S from PA posted over 2 years ago:

    Is there any strategy in withdrawing from tax-deferred accounts before RMDs are required so as to spread out, and thus reduce the yearly, withdrawals?


    Charles Rotblut from IL posted over 2 years ago:

    Stephen,

    Any money you withdraw from a traditional IRA (or similar type of tax-deferred retirement account) will trigger capital gains taxes.

    If you convert your IRA to a Roth IRA, you will avoid having to take RMDs, but you will pay taxes at the time of the conversion.

    -Charles


    R Dill from WY posted about 1 year ago:

    Charles,

    I'm confused by your answer to Steven above On IRA withdrawals. You make is sound like they can be taxed at L-Term Cap gains rates buy just withdrawing them early. Is that true??


    Charles Rotblut from IL posted about 1 year ago:

    R,

    That was a typo on my part. It should have said will trigger income taxes. The withdrawals will be taxed at the marginal tax rate.

    -Charles


    Dave Gilmer from WA posted 6 months ago:

    The article did not make it clear and there seems to be some confusion among the comments but in the case of any differences between tax-free accounts (Roth) and tax-deferred accounts (IRA, no non-deductible $) there is no difference if you hold tax rates equal (in & out) over time for these accounts.

    In other words it does not matter what you put in the Roth or IRA (as long as it's legal) or what rates of return the investment gets, if you swap the investments between accounts your final outcome will be exactly the same amount of money, provided you started with equivalent pre-tax money. For example for a 25% tax rate that would mean starting with $7500 in the Roth and $10,000 in the IRA.

    Many people think they want investments with the greater return in the Roth over the IRA. This is just not true if you do the real math.


    You need to log in as a registered AAII user before commenting.
    Create an account

    Log In