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All too often, individual investors overlook or underestimate the importance of having a sound asset location strategy.
In reading about investing, you’ve probably seen numerous discussions of asset allocation. Probably less often, you’ve seen the term “asset location.”
This isn’t a typo. Rather, it’s the process of deciding what types of assets should be held in what types of accounts.
All too often, individual investors overlook or underestimate the importance of having a sound asset location strategy. Failure to address this critical aspect of portfolio management often means paying taxes that could easily have been avoided or deferred, and being financially hamstrung by a lack of control over taxable events. And there’s an even greater cost—reduced flexibility in investment management, leading to suboptimal long-term financial planning outcomes.
Investors owning assets in a wide range of classes and holding different types of accounts with different tax treatments have far more options for asset location. Of course, with increased options comes increased complexity.
Rules of the Road
Yet there are some basic rules of the road for all investors to keep in mind.
Taxable accounts are usually a good place to keep individual stocks, as their dividends are often qualified, which usually means a lower tax rate than from ordinary dividends, which are taxed as ordinary income, i.e., at your income tax rate. Keeping stocks in taxable accounts confers more control over withdrawals, and it saves room for higher-taxed investments in tax-deferred accounts such as the individual retirement accounts (IRAs) held by many physicians.
Taxable bonds, which are taxed at the ordinary income rate, should probably go in IRAs, or, for physicians who work as employees, in their 401(k) accounts (also tax-deferred). This also applies to REITs and many other income-yielding investments that often pay ordinary dividends.
Yet, as location philosophies vary with an individual’s investment goals and strategy, other choices may make more sense. For example, in a rapidly ascending market, an individual might want to keep some individual stocks in an IRA to defer accumulated capital gains tax stemming from frequently trading appreciated shares.
Whatever your path, the key is to maintain flexibility by owning diverse asset classes and, preferably, maintaining different types of accounts with different tax statuses. This can help investors reach their long-term investing goals without paying more tax than necessary. Moreover, this flexibility is essential for navigating ever-changing tax laws.
More Nuance
Here are some more nuanced considerations for asset location:
Tail Wagging the Dog
Asset location isn’t just about tax mitigation. More importantly, it’s also about creating financial planning opportunities. However, you must be careful not to let the tax tail wag the investment dog. Even though an investment might have a more favorable tax treatment in a given type of account, it still might have lower potential for total net return than other available options.
Tax considerations should be a strong component of asset location strategies, but they aren’t the whole enchilada. To the extent that tax considerations are a priority, it’s critical to remember that tax laws are constantly changing, and your location strategy should change accordingly.
Dave Sheaff Gilreath, CFP, is a partner and chief investment officer, and Tiffany VanHook, JD, a wealth manager and vice-president, at Sheaff Brock Investment Advisors, LLC, an investment and portfolio management firm for individual investors. Gilreath is also a partner and the chief investment officer of Innovative Portfolios, LLC, an institutional money management firm. Based in Indianapolis, the two companies and their affiliated firms manage about $1.3 billion in assets nationwide.
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