Ways to Offset Interest Income with Asset Location
As you know, taxes are one of those events that are hard to avoid. However, there are ways that you can reduce your tax burden by reducing your taxable income from interest, dividends, and capital gains. There are two primary ways to organize your investments that will minimize the taxes you pay.
- Own interest-producing investments inside of tax-free and tax-deferred retirement account.
- Own capital gain and qualified dividend-producing investments outside of retirement account.
This process of choosing which types of accounts hold particular investments is called asset location.
Short-Term Retirement Account Income
There are several reasons that asset location strategies work to reduce taxable income. First, interest income and short-term capital gains are taxed at a higher rate than long-term capital gains and qualified dividend income.
When you hold investments that pay interest income or realize short-term capital gains inside of a retirement account you create savings. These payments are not reported as taxable income each year. The only time you report this income—and pay taxes on the money—is when you make a withdrawal. Since these are retirement accounts, withdrawals will usually be done at a lower tax bracket later in life. Also, rollovers and transfers—like when you change companies—when done properly, don't count as withdrawals and don't create a tax situation.
Investments Outside of Retirement Accounts
When you own income-producing investments outside of retirement accounts, those that have a loss can be sold to generate a capital loss. Capital losses can be used to offset other capital gains made in that tax year. You cannot generate capital losses from investments when they are owned inside of retirement accounts. Also, there is a limit on the total amount of losses you can claim each tax year.
Qualified and Long-Term Investment Income
When you own investments that generate qualified dividends and long-term capital gains inside of the tax-deferred retirement account, you negate lower tax-advantaged rates. All withdrawals from tax-deferred retirement accounts are taxed at your ordinary-income tax rate.
A Simplified Example of How Asset Location Reduces Your Tax Bill
Below is a simplified example that shows someone who has an allocation of 50% of their investment capital into stock or a stock mutual fund and 50% into bonds or certificates of deposit (CDs).
In this case, they own all the stocks and stock mutual funds in their individual retirement arrangement (IRA) and hold all of their bonds and CDs in a non-retirement brokerage account.
Location Strategy 1: Non-tax Efficient Portfolio
- IRA Account: $100,000 in stocks and stock mutual funds
- Non-Retirement Account: $100,000 in bonds/CDs yielding 5% on average
This $100,000 is producing $5,000 of taxable income that flows through to your tax return each year. You must pay tax on the $5,000.
Location Strategy 2: Tax-Efficient Portfolio
- IRA Account: $100,000 in bonds or CDs yielding 5% on average
Now, no taxable income is reported each year, unless you choose to take withdrawals from your IRA account.
- Non-Retirement Account: $100,000 in stocks and stock mutual funds
Capital gains must be reported each year, but now when there are losses, they can be used to offset capital gains. At most, you might expect about $3,000 of total long-term gains and qualified dividends per $100k invested in a large-cap index fund.
Also, the long-term capital gains are taxed at a lower rate than interest income, and in some cases are not taxed at all. And, you can use passive index funds which can significantly reduce annual capital gain distributions.
Assume someone is in the 25% tax bracket. In the first portfolio, they would pay $1,250 a year in taxes on the $5,000 of interest income.
In the second portfolio, the $3,000 of long-term cap gains and qualified dividends would be taxed at 15%. So, that taxpayer in the 25% bracket would pay only $450 on the gains. That's $800 a year of savings—and as the accounts grow larger, the tax savings increase.
Keep Your Reserves Set Aside
Of course, common sense says you would not invest all your non-retirement account money into stocks and stock mutual funds. You must keep an adequate amount of money in cash reserves in non-retirements accounts as an emergency fund.
Cash reserves in emergency funds are typically invested in things like money markets, CDs and other safe investments that will generate taxable income.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.