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Tax Increases Require Revised Asset Location Strategies

By: Richard Feldman

By: Richard Feldman, MBA, CFP®, AIF®

Choosing the location of where your assets are invested 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. Structuring the location of assets between taxable and tax deferred accounts properly can alleviate this problem and lead to greater after tax returns.

Tax-Deferral

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 versus taxable accounts.*

The asset allocation decision has become more complicated with the impending repeal of the Bush tax cuts and the new healthcare tax which is scheduled to take effect in 2013. The spread between the highest ordinary income tax rate and long term capital gains rate currently is 20% (35 percent less 15 percent), the repeal of the Bush tax cuts will narrow the spread to 19.6% (39.6 percent less 20 percent) on capital gains but will significantly increase the tax liability on qualified dividend income from the current 15% tax rate. To follow is a chart of the top federal future tax rates for different types of income:

Tax Bracket

Every investors 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.

In addition, a review of your tax return and previous years Form 1099 from your taxable brokerage account will show you how much in qualified dividend income you received as well as how much in capital gains distributions were distributed in 2009.

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.

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 has 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. REITs held in taxable accounts are all taxable at ordinary income tax 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 individuals marginal tax rate which can be as high as 35% in 2010 and 39.6% in 2011 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.

Fixed Income Investing: Investors have the ability to either hold fixed income in their taxable accounts in the form of taxable or tax-free bonds (Municipals) or hold taxable bonds in their retirement accounts. The increase in tax rates will make municipals more competitive on an after tax basis.
Conclusion
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.

There has yet to be a final decision made on the Bush tax cuts and whether they will exempt taxing dividends at higher rates for individuals and families making less than $200,000 and $250,000 respectively. As the law now stands the Bush tax cuts will expire at the end of 2010 and dividends will be taxed as ordinary income and capital gains will revert back to a 20%.