The role of asset location

Abram Claude, Vice President, Columbia Management Learning Center | November 18, 2014

  • Financial advisors and investors should have a good understanding of what is different about taxation in 2013 and beyond – and how it affects after-tax returns.
  • An asset location strategy should consider the benefits of placing less tax-favored investments under tax-deferred or tax-free registrations in order to increase after-tax returns.
  • The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.

The tax elements resulting from the American Taxpayer Relief Act and the taxes associated with the Affordable Care Act beg reconsideration of the adage, “It’s not what you make, it’s what you keep.” In other words, financial advisors and investors should have a good understanding of what is different about taxation in 2013 and beyond, how it affects after-tax returns and then consider ways to meet investment objectives while increasing after-tax returns.

The tax tail should not wag the investment dog. The investment strategy and asset allocation approach come first. But once that is in place, it can be beneficial to apply asset location as a follow-on strategy that considers the benefits of placing less tax-favored investments under tax-deferred or tax-free registrations in order to increase after-tax returns. This strategy could be particularly effective with respect to income producing investments, once you consider the range of tax treatments.

For example, take municipal security interest, which was left unchanged by the American Taxpayer Relief Act of 2012 and, therefore, generally continues to be federally tax-exempt. The tax-exempt interest neither counts under modified adjusted gross income nor does it count under net investment income — two of the components investors use under the 3.8% net investment income tax regime to determine their exposure.

Or consider the income from dividend-paying stocks, which often qualifies for qualified dividend treatment. Qualified dividends are taxed at the corresponding general long-term capital gains rate that would apply to the realization of long-term capital gains on the sale of the security. For gains otherwise taxed over the 15% income tax bracket, but below the 39.6% bracket, the long-term capital gains rate is 15%. For gains otherwise taxed in the 39.6% income tax bracket, the long-term capital gains rate is 20%. Long-term capital gains and qualified dividends are not the least tax-sensitive gains income, but they aren’t the most tax-sensitive either.

The income from corporate bonds or other (federally) taxable fixed-income securities is taxed as ordinary income. For someone who is subject to the 15% long-term capital gains rate or higher, that means their bond interest could be taxed at a rate as much as 25%, 28%, 33%, 35% or 39.6% (the income could be taxed at more than one of these rates depending on the overall taxable income for a particular investor). Taxable fixed-income is highly tax-sensitive, comparatively speaking.

In addition, investments held in taxable accounts could face the additional tax burden of the 3.8% net investment income tax.

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An asset location strategy should increase after-tax return now and in the near future without diminishing the value in the more distant future. Since interest from taxable fixed-income is taxed at ordinary income rates, as are taxable distributions from IRAs and qualified plans, the benefit of tax-deferred growth while in the IRA may be attractive.

Plus, distributions from IRAs and qualified retirement plans are not included under net investment income, and since the net investment income tax applies to the lesser of the amount over a triggering threshold and the amount of net investment income, this could be a tax-savings factor during the distribution years. Note that taxable distributions from retirement plans do increase modified adjusted gross income, so there can be 3.8% net investment income tax consequences for other income or gains.

Financial advisors and investors may want to review the following points.

In taxable accounts:

  • Could a greater allocation to municipal securities contribute to meeting income objectives while keeping the investor below certain tax thresholds or lessening the amount of net investment income? In your investment allocations decisions: Have you compared dividend-paying equities to taxable fixed-income with regard to yield and after-tax return?
  • In your investment location decisions (taxable or tax-deferred account): If you receive preferential tax treatment from qualified dividends now, have you considered what your highest marginal tax bracket could be in retirement and if that preferential treatment will still be in place then?

Regarding taxable fixed-income

  • Should a greater percentage of taxable fixed-income securities be located in tax-deferred (e.g., traditional IRA or qualified retirement plans) or potentially tax-exempt accounts (e.g., Roth IRAs)? What mix in investments in my accounts earmarked for retirement are going to get me to my financial goals, considering risk, time horizon, rate of return and tax consequences? This is a particularly important concern for an investor who is employed and not living off of the income presently.
  • Should working investors expand their IRA holdings before retirement through such steps as in-service distributions and rollovers from their qualified retirement plans, or consolidating retirement accounts? This tactic could increase flexibility and capacity in executing an asset location strategy.

Of course, investors should always consult their personal tax advisors and or legal counsel before making any investment or financial planning decisions.

Listen to our Road Report Podcast

Hear members of our Columbia Management Learning Center National Speakers Bureau discuss “Asset Location and the Quest for After-Tax Returns:”


Next in our series:

  • Considerations in exercising stock options under the new tax regime

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This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.