What is asset tracking?

Asset localization is a tax minimization strategy that helps investors optimize their portfolio by taking into account the tax treatment of different asset types. investments. Investors can maximize their after-tax returns by placing specific securities in either tax deferred or taxable accounts. But how does asset location help minimize taxes, and how can you apply this strategy to your own investments?

Achieve Optimal Asset Location

While asset localization is a powerful tax strategy, it should be considered complementary asset allocation— the process of distributing investments (shares, funds, other holdings) between different sectors to reduce risks. Only after you have determined the appropriate asset allocation for your portfolio should you consider the tax benefits of where to place each investment.

The best location for an investor’s assets depends on factors such as your financial profile, tax laws, investment. detention periodsand the tax characteristics of individual securities.

Tax-advantaged stocks should be held in taxable accounts because of their lower capital gains, dividend tax rates, and ability to carry forward gains. Riskier, more volatile investments belong in taxable accounts, both because of the ability to defer taxes and the ability to capture tax losses on poorly performing investments sold at a premium. recognized loss.

Index funds and exchange-traded funds (ETFs)are valued for their tax efficiency and should also be held in taxable accounts, just like tax-exempt or tax-deferred bonds. Taxable bonds, real estate investment trusts (REIT) and related mutual funds should be held in tax-deferred accounts, to avoid higher ordinary tax rates on interest payments and dividends.

Who benefits from asset localization?

You need investments in taxable and tax-deferred accounts to take full advantage of asset location. Generally, investors with balanced investment strategy composed of both stocks (stocks) and fixed income investments (bonds) can reap the most benefits. Although investors holding only stocks or fixed income can still benefit, the benefits are more pronounced in a balanced strategy.

A typical investor with a balanced portfolio (for example, 60% stocks and 40% bonds) may hold different types of assets in taxable and tax-deferred accounts. For example, stocks or stock funds would be better placed in taxable accounts, while fixed income investments should be placed in tax-deferred accounts like a IRA or 401(k).

Asset Location for a Balanced Portfolio

Let’s take the example of an investor whose portfolio is made up of 60% stocks and 40% fixed income securities. The goal is to position assets to minimize taxes while maintaining the same overall asset allocation:

• Tax-deferred accounts (such as an IRA or 401(k)): Hold 40% fixed-income investments (e.g., bonds) in these accounts because bond interest is taxed at ordinary income rates.
• Taxable accounts: here hold 60% equities (e.g. stocks, stock mutual funds), such as long-term capital gains and qualified dividends are taxed at favorable rates (0%, 15% or 20%).

This strategy ensures that taxable income from bonds is deferred and taxed at a lower rate, while the more tax-efficient returns from stocks are taxed at preferential rates.

If an investor is withdrawing funds from tax-deferred accounts or will do so soon, the advantage of asset location is greater than for younger investors who still have many years before they begin withdrawing funds.

Suppose an investor has accumulated $20,000 in capital gains and dividends in a traditional individual retirement account (IRA). The investor takes the entire amount as a distribution, which is then treated as ordinary income. If the taxpayer falls into the 35% tax bracket, the investor would be left with $13,000. If the investor had realized $20,000 of long-term capital gains and qualified dividends in a taxable account, the tax would have been only 15%, leaving him with $17,000.

How asset location minimizes taxes

How a title is taxed will determine where it should be located. Long-term capital gains and qualified dividends receive favorable rates of 0%, 15% or 20%, depending on your income level. Meanwhile, taxable interest is reported on Form 1040 and is subject to ordinary income rates, which vary between 12% and 35%.

Since most stock investments generate returns from dividends and capital gains, investors realize lower tax bills when they own stocks or shares. mutual funds in a taxable account. These same capital gains and dividends, however, would be taxed at the ordinary rate (up to 37%) if withdrawn from a traditional IRA, 401(k), 403b)or another type of retirement account where taxes are paid on the withdrawal of funds.

Fixed-income investments such as bonds generate a steady cash flow. These interest payments are subject to the same ordinary income tax rates of up to 37%.

The essentials

Asset localization is a strategy that aims to maximize after-tax returns by placing investments in accounts with the most favorable tax treatment. The key to effective asset location is understanding your financial profile, tax situation and investment time horizon. By thinking carefully about where to place your taxable and tax-deferred investments, you can potentially reduce your overall investment. tax obligation and improve the long-term growth of your portfolio.