By: Richard Feldman
By: Richard Feldman, CFP, AIF, MBA
Choosing the location of where your investments are located can add significantly to your after tax returns. Most people understand that modern portfolio theory and asset allocation are major factors in determining investment returns but individuals are not as well versed in techniques of asset location. Capital gains distribution season just ended and investors are going to be surprised by the amounts of capital gains distributions generated by their mutual funds. Capital gains distributions have been relatively non existent because of market losses suffered through the 2000 to 2002 market years. Mutual funds accumulated sizable losses and therefore had embedded capital losses that offset capital gains that were realized by mutual funds in subsequent positive market years of 2003 and 2004. In 2005 investors realized substantial capital gains distributions on investments that are marginally positive or even negative. Paying taxes on investments that have lost money is typically not a great experience. Structuring the location of assets between taxable and tax deferred accounts properly can alleviate this problem and lead to greater after tax returns.
The ability to invest on a tax-deferred basis is valuable to investors because it allows them to shelter capital gains and income from current income taxes. However, because assets differ in terms of tax liabilities they create for investors, the value of tax-deferred investing will depend upon which assets are held in the tax-deferred account.
The asset allocation decision has become more complicated with the passing of the last tax act. The spread between the highest tax bracket rate and the capital gains rate before JGTRRA was 18.6% (38.6 percent less 20 percent). As a result of the new tax law, the spread increased to 20% (35 percent less 15 percent), making planning for the allocation of investments across taxable and tax-deferred accounts even more important. If you reside in a state that has high local and state taxes the spread is even greater. Throw in the reduction on qualified dividends to 15% or 10% if you are in the 10 or 15 percent bracket and you can see why it has become so complicated.
Every investor’s situation is different so there is no universal answer in deciding where to hold assets. Generally, the first information to gather is the breakdown of taxable versus tax-deferred investments and then decide on an overall asset allocation structure based on your own risk tolerance.
Take a hypothetical person who has $500,000 evenly split between a retirement plan and a taxable portfolio. Based on this person’s age, goals, and risk tolerance, he and his advisor have developed an asset allocation model of 60% equities, 10% REITs, 10% Commodities and 20% fixed income.
The ultimate goal is to grow the total portfolio while keeping taxes to a minimum. In other words the ultimate goal is the highest total after tax rate of return.
Is the most optimal allocation to place the 40% (REITs, Commodities, and Fixed Income) in the retirement plan or some combination of equities, fixed income, and REITs between the two accounts?
If stocks are held inside a qualified plan or tax-deferred vehicle, the tax advantages of capital gains are lost. Any capital gains will ultimately be turned into ordinary income, upon withdrawal. On the other hand, stocks can be expected to outperform fixed income over a long term time period. The dilemma lies in putting all fixed income type assets in a tax-deferred vehicle in order to save on income taxes thus giving up some growth potential of the retirement vehicle. Making the problem even more complicated is the fact that individuals can use municipal bonds in their taxable accounts for their fixed income exposure.
Factors to Consider
Liquidity Issues: If an individual allocates most or all of his taxable accounts to equity, the investor may face liquidity problems if the value of equity declines substantially and he incurs a need to take a distribution. This can give an individual some incentive to hold some bonds in his taxable account in order to reduce the risk of liquidating equities at an inopportune time.
REITS: REIT shares deliver current income in the form of high-yielding dividend payouts, plus potential for capital gains, plus the advantage of diversification. Inside a retirement account these are all fine attributes. Inside a taxable account, however, REIT shares don’t receive the same favorable tax treatment as equities. Most REIT dividends will not be eligible for the 15%/5% rates.
Commodities: Commodities distributions typically are derived from gains on futures contracts. Taxation of futures contracts are typically 60% long term capital gains and 40% short term capital gains. Short term gains are taxed at an individual’s tax bracket which can be as high as 35% making it optimal to hold commodity funds that are futures based inside tax deferred accounts.
Date of Death Step Up: Highly appreciated equity investments receive a step up in basis when held in taxable accounts thus allowing your heirs to receive assets with no tax consequences.
Tax Bracket: The smaller the gap between capital gains and dividend treatment and ordinary income tax rates the smaller the incremental benefit of placing fixed income and REITS in your retirement accounts.
Tax Loss Harvesting: Capital losses incurred inside your IRA are lost forever whereas losses incurred in a taxable account may be used to offset ordinary income as well as future capital gains.
Foreign Tax Credit: Both individual taxpayers and corporations may claim a tax credit for foreign income tax paid on income earned and subject to tax in another country or a U.S. possession. As an alternative, a taxpayer may claim a deduction instead of a credit. The purpose of the FTC is to mitigate double taxation since income earned in a foreign country is subject to both U.S. and foreign taxes. International and foreign funds held in a tax-deferred plan lose the ability to claim a FTC on foreign income tax paid.
Tax Managed Mutual Funds: Investors have access to tax managed funds that use sophisticated algorithms to minimize distributions and capital gains for taxable investors and still maintain high correlation to asset class returns.
The optimal allocation of investment assets across taxable and tax-deferred accounts combines a number of variables that need to be considered before making any decisions. Academic research varies on the exact science of asset location. Typically each individual investor has a number of issues that will drive asset location decisions. These issues typically involve saving for down payments on housing and college funding. Focusing on after tax rates of returns, liquidity needs, and efficient allocation of your investment assets will allow investors to build a larger investment portfolio, reduce taxes, and earn higher after tax rates of returns.
 Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing, Dammon, Spatt, and Zhang