Tax smart investing

Reduce taxation through asset location

You’ve likely heard the number one rule of real estate: location, location, location. A beautiful cape cod with a white picket fence is worth significantly less if it’s located in the middle of an industrial zone versus a quiet suburban neighborhood. Similarly, a stellar-performing portfolio will reap lower rewards in the end if the assets are not located in the right accounts to optimize tax efficiency.

While individual circumstances can vary, every investor can benefit from understanding how the location of an asset can impact their tax cost. And – no surprises here – the higher your tax rate, the bigger the impact.

When thinking about where to place your assets, start with the big picture. It makes sense to generate your highest returns where you won’t pay taxes on them, hold your most tax-efficient assets where you will be fully taxed, and defer taxation for assets that pay lower returns with minimal capital gains.

Start with the big picture to minimize tax costs

Asset Location Venn diagram

Shoot for higher returns in tax-exempt accounts

Tax-exempt accounts, such as a Roth IRA, are funded with post-tax dollars and therefore do not pay taxes during accumulation nor upon withdrawal. This is the ideal place to hold the assets you expect will generate high returns, such as stocks. Active stock strategies such as mutual funds that outperform the market derive the biggest benefit from a Roth account’s tax exemptions.

Let lower returns lie in tax-deferred accounts

Tax-deferred accounts, such as a traditional IRA, are generally not taxed during the accumulation period; however, because they are funded with pre-tax dollars, you will ultimately pay tax upon withdrawal at your ordinary income tax rate. The good news is that rate is likely to be lower after you’ve retired than it was during your working years. Nevertheless, you will be taxed, which makes this account the right place to hold assets with lower expected returns.

Taxable bonds, especially high yield, and real estate investment trusts (REITs) are well suited for tax-deferred accounts because they are not as likely to produce capital gains. Assets that produce capital gains are better suited for a taxable account, where you can take advantage of a lower tax rate on long-term capital gains. In a tax-deferred account, any capital gains would be taxed as ordinary income.

Keep tax-efficient assets in taxable accounts

Taxable accounts are funded with post-tax dollars and your investment earnings will be taxed both during the accumulation phase and upon withdrawal. This is where you should hold your most tax-efficient assets. This is also where you may benefit from holding assets longer than one year. The long-term capital gains rate is lower than the ordinary tax rate for most individuals.

Choosing which bonds to hold in a taxable account hinges upon your individual tax rate. Municipal bonds offer tax-exempt income, while taxable bonds typically provide more generous yields. The key is to determine which provides the better after-tax return given your tax rate. For individuals in high tax brackets, the tax-equivalent yield on a municipal bond is often higher than the yield on a comparable taxable bond.

For stock exposure, exchange traded funds (ETFs) may be a good choice for taxable accounts because they are usually structured in a way that results in very little or zero capital gains distributions paid to shareholders each tax year, which means little or zero taxation during the holding period.

Outperformance is welcome anywhere… if it’s worth it

While actively managed mutual funds may not be as tax efficient as ETFs, they offer the potential for higher returns. The pursuit of strong performance naturally drives a level of portfolio turnover – and thus, taxable capital gains – that you wouldn’t typically see in an index ETF. And given the open-ended structure of mutual funds, active managers may be forced to make tax-inducing trades to raise cash for shareholder redemptions.

Despite this “tax drag,” an active mutual fund can still be appropriate for a taxable account if the level of expected outperformance is high enough to compensate for the anticipated tax cost, which depends on your personal tax rate.

While it’s impossible to predict with certainty how much outperformance or tax drag an active mutual fund will produce, historical data can help you formulate projections and consider whether it is still a worthy investment after taxes. If the answer is “no,” remember that the matter of tax drag doesn’t apply to tax-exempt or tax-deferred accounts.

What matters most for you?

The strategies discussed in this article represent a basic framework for asset location. How you can make the most of these insights depends on your particular situation, including:

  • Your tax bracket. The higher your tax rate, the more you have to lose if your assets are not held in the right accounts. However, if your tax rate is relatively low when you start taking withdrawals, the location of your assets will not be as critical.
  • Your asset allocation. If your investments are fairly concentrated in one asset class, the location of your assets matters less than it would if you hold a balanced mix of stocks and bonds.
  • The dispersion of your assets among accounts. If you hold roughly the same amount of eggs in each of your baskets, the type of investments held in each account will have a more meaningful impact on your outcomes after taxes versus a scenario where the bulk of your assets are held in one account.

The location of your assets can play a critical role in helping you keep more of the wealth you have grown over time. The impact of taxes associated with allocating assets across accounts should be analyzed alongside investment performance potential, account fees and other considerations, within the context of your personal circumstances. Financial and tax professionals working in tandem can help investors achieve optimal tax efficiency.

If you are a financial professional, reach out to your local BlackRock market team to see how you can partner with BlackRock and Aperio to build and manage portfolios that reflect your clients’ unique tax considerations.