Tax efficient asset location - financial advisor ꟾ BlackRock

AFTER-TAX RETURNS

May 1, 2024

BlackRock

What advisors need to know

As high market dispersion creates opportunities for significant outperformance in 2024, tax-aware advisors have an opportunity to showcase their value by helping clients keep more of what they earn.
In addition to choosing tax-efficient investments, allocating investments to the right account types can help you achieve optimal tax efficiency.
Maximize after-tax outcomes for your clients by incorporating asset location strategies into your investment process.

The potential for significant capital gains in 2024 calls for a keen focus on tax strategy

A high level of dispersion in stock performance created spectacular opportunities for skilled stock pickers in 2023, and elevated dispersion continues to be a market theme thus far in 2024.
Some of last year's winners have continued to reward their investors while roughly 40% of the stocks in the S&P 500 have declined year-to-date (as of 4/30/24).

In this environment, active fund managers have opportunities to capture idiosyncratic stock returns and deliver strong outperformance to their investors, and advisors who know how to pick the right fund managers have the potential to deliver strong gains to their clients. If you’re seeking a piece of the action, be intentional about placing investments where the tax treatment will be most favorable for your client.

Asset location impacts your clients’ taxation

Where you place a client’s assets can have a meaningful impact on after-tax returns, especially for clients who are subject to a high income tax rate. An asset location framework can help you reduce tax costs for your clients.

Asset location framework for optimal tax treatment

Read on to better understand how to allocate your clients’ assets across account types to optimize after-tax outcomes.

Use our tax evaluator tool to view capital gains estimates and identify tax loss harvesting opportunities in your portfolio.

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Take advantage of tax-advantaged accounts

Tax-exempt accounts, such as a Roth IRA or Roth 401(k), are funded with post-tax dollars and therefore qualified distributions are not subject to taxation. This is the ideal place to hold the assets you expect to generate the highest returns. Actively managed equity mutual funds that seek to outperform the market may derive the biggest benefit from a Roth account’s tax exemptions.

Tax-deferred accounts, such as a traditional IRA or 401(k), are generally not subject to taxes during a client’s accumulation phase; however, their pre-tax or tax-deductible contributions will ultimately be taxed – along with earnings – upon withdrawal at the client’s ordinary income tax rate. The good news is that your client’s tax rate may be lower in retirement than it was during their accumulation years. Taxable bonds, including high yield bonds, and real estate investment trusts (REITs) are well suited for tax-deferred accounts because they tend to generate income (vs. capital gains), which will be taxed at the client’s ordinary income tax rate. But the tax-deferred account allows the client to delay this taxation until withdrawal instead of having to pay in the year the income was earned.

Minimize taxable earnings in taxable accounts

Taxable accounts are funded with post-tax dollars but the interest and dividend earnings on the investments will be taxed annually and unrealized appreciation will be taxed upon sale. This is where clients should hold their most tax efficient assets.

When you are choosing which bonds to hold in a taxable account, focus on after-tax returns for the individual client. Municipal bonds offer tax-exempt income, while taxable bonds typically provide more generous pre-tax yields. For individuals in high tax brackets, the tax-equivalent yield on a municipal bond can be higher than the yield on a comparable taxable bond.

For stock exposure, indexed investments including exchange traded funds (ETFs), active ETFs and some separately managed accounts (SMAs) can be good choices for taxable accounts because they are usually structured in a way that minimizes or eliminates capital gains distributions paid to shareholders each tax year. As long as the asset is held longer than one year, gains will generally be taxed at the long-term capital gains rate, which is lower than the ordinary income tax rate for most individuals. Additionally, dividends paid by indexed equity investments are more likely to be considered qualified and therefore also taxed at preferential rates.

Above all, after-tax return is the deciding factor

While actively managed mutual funds seek to provide higher returns, the pursuit of strong performance often drives a level of portfolio turnover – and thus taxable capital gain distributions – that is far higher than 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. Altogether, the effects of trading can create a “tax drag” on active mutual funds.

The potential for outperformance coupled with the potential for tax drag makes actively managed equity mutual funds an ideal asset for tax-exempt accounts. That said, tax-exempt accounts have limits on contributions. If you’ve already filled your client’s tax-exempt accounts, it can still make sense to hold active equity mutual funds in a tax-deferred or taxable account as long as the level of expected outperformance is high enough to compensate for the anticipated tax cost, which depends on the client’s personal tax rate.

Consider your client’s circumstances

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 client’s unique circumstances, including:

Tax bracket. The higher your client’s tax rate, the more they have to lose to taxes if the assets are not held in the right accounts.
Asset class diversification. If your client’s investments are fairly concentrated in one asset class, determining the optimal location of the assets may be less complicated than it would be for a balanced mix of stocks and bonds.
Account allocation. If your client holds roughly the same amount of assets across different account types, the type of assets held in each account will have a more meaningful impact on the client’s after-tax returns versus a scenario where the bulk of the assets are held in one account. As no one can be certain what their personal circumstances and tax rates will look like in the future, owning multiple types of accounts provides tax diversification and enhances tax planning flexibility.

Deliver better after-tax returns with a tax efficient asset location strategy

If your clients are seeking to capitalize on the high level of dispersion in the stock market today, consider the impact of taxes that comes with strong returns and strategize accordingly. Place assets in the right accounts to optimize after-tax returns for your clients.

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 client’s 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.