Asset Placement Tax Strategy

Lowering Your Tax Liability Through Intelligent Allocation

With smart and proper planning, allocating certain types of assets into specific accounts can help reduce your annual tax liability.
With smart and proper planning, allocating certain types of assets into specific accounts can help reduce your annual tax liability. Sam Edwards/Getty Images

It may surprise many new investors to discover that two people with identical portfolios can have widely disparate results over the course of several years.  The reason arises from asset placement; in other words, where you hold your investments can be just as important as which assets you select.  As you learned in The Complete Beginner's Guide to Capital Gains Taxes, understanding this concept is vital for you and your pocketbook.

How asset placement works

What matters in investing is the compound annual after-tax, inflation-adjusted return an investor earns on his capital.  Read that sentence again: after-tax.  Learn how to calculate compound annual growth rate (CAGR).  Those of you familiar with the time value of money equations know that seemingly small-amounts can add up to significant piles of cash if left alone.  If you have amounts even as little as $100 or less a month to invest, there are ways you can begin constructing a meaningful investment portfolio.  Every time a portion of your returns gets siphoned off to Uncle Sam, the future value of the asset is greatly diminished because not only have you lost the money itself, you have lose all of the profit that could have been earned by investing that money.

Asset placement works because different types of investments receive different tax treatment. Depending upon the length of time an asset is held, for example, income arising from capital gains is taxed at significantly lower rates than dividends and bond interest.

 In the cases of higher-income households, the tax on the latter type of income can sometimes reach as high as 35%.  Thus, by simply placing all of his high-yielding stocks and corporate bonds in his tax-advantaged accounts, an investor can immediately realize significant tax savings that can sometimes amount to tens of thousand of dollars a year and, ultimately, millions more in assets over the course of a successful investment lifetime.

A simple example of how asset placement can save you money

Imagine you have a portfolio valued at $100,000. Half of your assets, or $50,000, consists of investment grade bonds earning 8% which generate $4,000 per year in interest income.  Twenty-five percent of the portfolio, or $25,000, consists of common stock with high dividends that generate $1,000 per year.  The remaining twenty-five percent, or $25,000, consists of common stocks that pay no dividends.

In this scenario, an investor in the 35% tax bracket would immediately save $1,750 per year by placing the high-yielding stocks and corporate bonds in his tax-advantaged accounts.  (To calculate that, add the $4,000 bond interest income and the $1,000 dividend income together to get $5,000.  35% tax on $5,000 is $1,750.)  It makes no sense for him to place his non-dividend paying common stock in such an account because he is not going to pay taxes on the profit until he elects to sell the investment; even then, he will be taxed at a rate fully half of what he would have paid otherwise!  For most investors, capital gains are taxed at 15%.

A Guide to Asset Placement

When deciding which type of accounts to place your assets such as corporate bonds and common stocks, generally speaking, let these few simple guidelines help you with your decision:

Assets that should be placed in tax-advantaged accounts (401k, IRA, etc.):

Assets that should be placed in regular, non-tax advantaged accounts (brokerage, direct-stock ownership, etc.):

  • Common stocks with little or no dividend payouts that you expect to hold for more than a year
  • Tax-free municipal bonds (since they are already tax-free, there is no need to place them in tax-advantaged accounts)