The Importance of Asset Location on Tax Strategy

Most of us know the importance of asset allocation—diversifying your investments to distribute risk evenly across your portfolio. However, when it comes to forming an asset location strategy, fewer investors have a well-formed plan. While it is important to have a diverse portfolio of investments to hedge against market volatility and help mitigate losses, concentrating the majority of your wealth into one specific asset location can leave your wealth vulnerable to unnecessary taxes and liquidity problems.

There are three main buckets for your investments. An asset location strategy involves determining in which bucket what type of investment should be placed and how much. The three buckets include pre-tax accounts, such as a 401(k) or traditional IRA; post-tax accounts, such as Roth 401(k) or Roth IRA; and taxable accounts, such as a brokerage account. Employing a thoughtful asset location strategy can help you remain in a tax-advantaged position as you continue on the journey of growing your wealth. What that strategy is depends on a multitude of factors including your age, risk tolerance, liquidity needs, and more. As wealth managers and investment advisors, Morgan Rosel investment advisors work with our clients to understand their needs and goals in order to development an asset location strategy that works for them. 

The Three Main Buckets

When using an asset location strategy to minimize your tax liability, it is crucial to distribute your investments among the three buckets using a thoughtful approach. Every investor has unique goals and investments, and because of this, the asset location strategy will vary from person to person. However, there are some basic guiding principles that tend to work well in most situations.

Asset Location 1: Pre-Tax Accounts

Accounts where you contribute funds pre-tax, such as a 401(k) or traditional IRA, are an excellent home for investments that lack natural tax advantages. Assets that are taxed as ordinary income tend to do well in a pre-tax account because taxes can be deferred until a later date. Typically, most people will have a reduced income tax rate following retirement, so this option attempts to maximize the investment today while minimizing the tax rate in the future.

It is important to note that investments placed into a pre-tax account remain relatively illiquid. If the account holder withdraws funds from a pre-tax account before the age of 59 ½, they will incur penalties and higher tax rates.

PROS

• Reduces taxable income
• Maximizes contributions before taxes
• Potential lower future income tax rate

CONS

• Illiquid until age 59 ½
• Incur penalties for premature distribution
• Traditional IRAs can cause complications with backdoor ROTH strategies used by high-net-worth investors

Asset Location 2: Post-Tax Accounts

Similar to pre-tax accounts, post-tax accounts are also considered to be tax-advantaged. Accounts that hold assets on which you’ve already paid taxes, such as a Roth IRA or Roth 401(k), allow your money to grow without the burden of paying additional taxes. Storing assets in a post-tax account is typically a good idea for people who anticipate the same or a higher income tax rate in the future.

PROS

• Funds will grow without incurring additional taxes
• Distributions are tax free

CONS

• May end up paying more taxes now if tax bracket is lower in future
• Income limits may prevent contribution to certain accounts
• Distributions before 59 ½ incur higher taxes

Asset Location 3: Taxable Accounts

Taxable accounts, such as online brokerage accounts, are ideal for holding tax-advantaged assets such as municipal bonds and investments where you want to maintain a higher level of liquidity. Assets kept in taxable accounts, such as stocks and bonds, can be sold off and/or reinvested. Most investments in taxable accounts will be subject to capital gains taxes, which are typically lower than ordinary income tax rates. This affords you the ability to use tax-loss harvesting techniques on under-performing assets.

PROS

• Most liquidity of all accounts
• Take advantage of tax-loss harvesting techniques

CONS

• Subject to taxes on realized gains
• No major upfront tax breaks

Creating an Asset Location Strategy

Unlike market prices and tax laws, asset location is one of the few things that you can control. Peopled don’t take advantage of their ability to determine the tax treatment each investment receives as often as they should. The same investment can receive a different tax treatment based on the account type, so determining an asset location strategy is important to maximizing returns. Before creating an asset location strategy, you will need to consider your current income tax rate, your expected post-retirement income tax rate, the duration you plan to hold the investments, and the current tax efficiencies of your assets.

Determining the most tax-efficient strategy for your investments isn’t easy, and making an uninformed decision may end up triggering significant unnecessary taxes. If you withdraw from a retirement account before the age of eligibility you could incur higher taxes and penalties. Even with a thoughtful plan, switching funds from one account to another may be considered a taxable event that eats into your profits. The easiest way to implement an effective asset location strategy is to consult with a knowledgeable wealth management team like Morgan Rosel Wealth Management.

The right team will have experience in asset location strategies and can highlight the potential tax consequences while outlining the possible benefits. We have developed a family office style approach to wealth management made up of a team of resources that include a Certified Public Accountant (CPA), investment advisors, and CERTIFIED FINANCIAL PLANNERS^TM. If you are interested in minimizing the tax obligations of your investments but are overwhelmed by the possibilities, Morgan Rosel Wealth Management is here to help. Contact us today to start a discussion with one of our experienced financial planners.