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

by Kevin Trout

An In Depth Look At The Tax Consequences Of Asset Location Splash image

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.

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About the author

Kevin Trout is an adjunct instructor and lecturer at Coe College and the University of Iowa, respectively, where he teaches Personal Financial Planning and Taxes and Business Strategy, among other courses.
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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.

General Guidelines

There are four general factors that indicate an investment is favorable for placement in a tax-deferred retirement account.

1. The investment is qualified to be placed in a tax-deferred retirement account. Not all investments are allowed in tax-deferred accounts. For instance, the tax code prohibits most collectibles from being held in an IRA. Exceptions to this rule allow certain U.S. gold and silver coins issued after 1986 as well as silver, platinum and palladium bullion to be placed in an IRA.

2. The investment’s returns are frequently subject to inclusion in taxable income when held in a taxable account. Either the returns are periodic, current income such as interest or dividends, or the investor anticipates a short holding period before the investment is sold and gains are recognized.

3. The investment returns are taxed at the high ordinary income tax rate, not a preferential, lower rate such as the 15% rate on qualified dividends and long-term capital gains applicable to many individuals.

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4. The investment has a relatively high rate of return. The more return an investment generates when held in a taxable account, everything else equal, the greater the tax liability.

Specific Advice

1. Original issue discount (OID) bonds, especially zero-coupon bonds, should be held in a tax-deferred account. The tax law requires taxpayers to impute interest on OID bonds and pay income tax on the imputed interest each year, despite not actually receiving cash for the imputed interest until the bond is sold or matures. On OID bonds, the taxpayer must pay tax on interest not received. This creates a negative deferral of tax, lowering the aftertax rate of return of OID bonds below similar-yielding non-OID bonds.

2. Appreciating “estate” assets with little or no current return, which are planned to be left to heirs, such as collectibles, real estate or land, should not be placed in a tax-deferred account. Income tax on the assets’ appreciation can be avoided through the step-up in basis, if transferred at death.

3. Tax-exempt municipal bonds should not be held in a tax-deferred account because the investor ends up paying tax twice. The reduced interest these bonds pay compared to similar-risk taxable bonds is considered an implicit tax. (An implicit tax is the lower return received on a tax-preferred investment because investors bid up the prices due to the reduced tax, lowering the pretax return below similar tax-neutral investments.) The explicit tax is paid when distributions are made from a tax-deferred investment vehicle; the distribution would be taxed at the ordinary tax rate.

4. Collectibles should generally not be placed in a tax-deferred account. First, many collectibles are prohibited from being held in tax-deferred accounts. Second, collectibles allowed by law to be in a tax-deferred account typically generate no current income and therefore allow for tax-deferral of any appreciation until sold.

The general guidelines and specific advice are helpful, but certain asset location decisions remain unclear. For instance, what happens when an investor is deciding between placing a stock or a bond in the tax-deferred account? The investor expects a higher rate of return on the stock, but the bond has more current income taxed at ordinary tax rates. In this case, the best asset to be placed in the tax-deferred account depends upon the expected return parameters of the stock and bond, the expected holding period of the stock and the personal tax rates applicable to the investor. In order to measure these seemingly ambiguous situations, a model has been developed and is available in the AAII.com Download Library at www.aaii.com/download-library/download?DL_ID=742.

Tax Deferral: A Large Benefit of Investing in a Tax-Deferred Account

The deferral of tax is a primary advantage of investing in a tax-deferred account. The longer the payment of the tax on an investment is deferred, the higher the aftertax return. The increased return occurs because the investor continues to earn a return on funds that would have been paid in taxes if the same investment had been held in a taxable account. In a taxable account, the tax law generally allows an investor to defer the tax on an asset’s appreciation until the asset is sold. For instance, with common stock, any appreciation of the stock is not taxed until the stock is sold. Table 1 shows the impact of a lengthening deferral period on an asset appreciating 10% per year when held in a taxable account at a tax rate of 15%. As the deferral period lengthens, the aftertax return increases, reducing the benefit received by placing the investment in a tax-deferred account.

As the deferral period increases, the aftertax rate of return approaches the pretax rate of return. At the extreme, if an investor holds an appreciating asset to the end of her life, then passes the investment to heirs, the heirs receive a step-up in basis equal to fair market value at the time of death. If the asset was sold immediately after inherited, there would be no income tax. In this situation, investor’s aftertax return equals the pretax rate of return.

Deferral Period Pretax
Rate of Return*
Aftertax
Rate of Return*
in Years (%) (%)
1 10 8.50
5 10 8.72
10 10 8.94
25 10 9.36
50 10 9.65
Until Death    
of Owner 10 10.00
*Assumes 10% annual appreciation and a 15% tax rate.
 

The Model

The model computes the annualized aftertax rate of return of investments if held in a taxable account and three different types of tax-deferred accounts. The model requires estimates of returns on the investment, the expected holding period, the time until the investment would be liquidated to make retirement distributions and the investor’s expected tax rates. To compute the aftertax annualized rates of return, some simplifying assumptions were required. First, each asset is assumed to generate constant annual returns from current income and/or capital appreciation. Such returns are measured as percentage yields, or the return divided by the investment’s value. Second, interim cash flows generated by the investment are assumed to be reinvested in a similar asset with the same return and tax parameters. Tax rates are expected to be constant throughout the investment period, but the investor’s expected ordinary tax rate applicable for distributions from tax-deferred accounts in retirement is not assumed to be the same rate. Tax-deferred accounts come in three varieties: deductible/excludible tax-deferred accounts (like the traditional IRA and 401(k) retirement plan), the Roth IRA or 401(k), and the non-deductible IRA. The model calculates annualized aftertax returns for each of the three tax-deferred account varieties.

Effect of Tax Rate Increases

Asset location is even more important now due to the new maximum dividend and long-term capital gains tax rates of 20% and the new 3.8% health care surtax on investment income for those with net investment income and modified adjusted gross income over $200,000 for single taxpayers and $250,000 for married couples filing jointly. See Table 2 for the maximum tax rates in 2013.

  Maximum
  Tax Rate*
Type of Income (%)
Ordinary Income 39.6
Interest Income 43.4
Qualified Dividend Rate 23.8
Ordinary Dividend Rate 43.4
Long-Term Capital Gains Rate 23.8
Short-Term Capital Gains Rate 43.4
 
*Includes 3.8% health care surtax on investment income.
 

Example

Assume an investor holds two investments in both a taxable account and a deductible/excludible tax-deferred account, such as a traditional deductible IRA or 401(k) retirement plan. The first asset is a bond paying 4% interest, selling at face value. The second investment is a stock with a projected 4% dividend yield, expected to realize 6% annual appreciation and intended to be held for 10 years. The investor has estimated it will be 30 years until the assets will be distributed from the retirement account.

Table 3 shows the annualized rate of return for the bond and the stock at the maximum tax rates effective this year. Using the new maximum tax rates for 2013, placing the stock in the tax-deferred account results in a 2.12% increased return, which exceeds the bond’s 1.74% differential. The stock should be the asset placed in the tax-deferred account because the investor realizes a larger increase in aftertax rate of return on the stock. In this case, the substantially higher expected total return on the stock more than offsets the fact that bond interest is taxed annually at ordinary tax rates.

  Annualized Rate of Return (%)  
    Tax-Deductible,  
  Taxable Tax-Deferred Differential
  Account Account (%)
Bond (4% Coupon) 2.26 4.00 1.74
High-Dividend Stock (4% Dividend Yield, 6% Annual Appreciation) 7.88 10.00 2.12
 

Impact of Higher Tax Rates

The new maximum tax bracket and new net investment income surcharge make it important to reassess your asset location decisions. For instance, bonds traditionally have been a better asset than stocks to place in a tax-deferred account because the interest is taxed annually at the ordinary tax rate. However, given the current low yield on bonds, and higher tax rates for some investors on dividends and capital gains, investors may find it preferable to place high-dividend stocks in a tax-deferred account instead of low-yielding bonds.

The benefit of placing an asset in a tax-deferred account increases with the higher tax rates and the investment income surcharge. The 3.8% surcharge on investment income is not applicable to distributions from these retirement accounts. With higher tax rates, even non-deductible IRA contributions become more attractive relative to taxable accounts, especially for those subject to the new surcharge.

Asset Location Dos and Don’ts

  • Do maximize 401(k) and IRA investments.
  • Do put original issue-discount (OID) bonds in a tax-deferred retirement account.
  • Don’t put municipal bonds in tax-deferred accounts.
  • Don’t put “estate assets”—assets with little or no current income, expected to be left to heirs—in a tax-deferred account. Let heirs receive a stepped-up basis by bequeathing the asset to them in your will.
Kevin Trout is an adjunct instructor and lecturer at Coe College and the University of Iowa, respectively, where he teaches Personal Financial Planning and Taxes and Business Strategy, among other courses.


Discussion

Gerald Lanois from FL posted about 1 year 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 about 1 year 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 about 1 year 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 about 1 year 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 about 1 year ago:

ditto on the comments by Gerald Lanois.


Robert Trout from IA posted about 1 year 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 about 1 year 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 about 1 year 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 about 1 year 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 about 1 year 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 about 1 year 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 19 days 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 18 days 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 16 days 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


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