The choice of investment placement can have a major impact on an investor’s taxes and net return after taxes.
How Asset Location Works
There are three basic types of investment accounts:
Brokerage Accounts
Investments held in a brokerage account are taxed on capital gains and on interest income, or money you earn from dividends. For example, if you sell a mutual fund at a price higher than what you paid for it, you will have a capital gain for which you will owe a tax. This is a tax on the fund’s net asset value. Any interest income earned on investments in a brokerage account is taxed as income, just as when you receive payment from an employer.
Tax-Deferred Accounts
The way tax-deferred accounts are taxed differs greatly from the way brokerage accounts are taxed. Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), will not result in capital gains taxes. In fact, selling funds in a tax-deferred account results in no immediate taxes at all. Other mutual fund fees may apply, though. Income from dividends is not taxed in IRAs or 401(k)s until you withdraw money at a later time, such as after you retire.
Tax-Exempt Accounts
In a tax-exempt account, investments are made with after-tax income, which means that you pay taxes on income before you invest it into the account, so it won’t be taxed again. Any money you earn within this type of account grows tax-free, so long as it stays in the account for a given length of time. The IRS places limits on how much you can invest in a tax-exempt or tax-deferred account. For instance, for the tax year 2021, Roth IRA phase-out begins at $125,000 in earnings for single filers, and for married filers it goes up to $208,000 in certain cases. In 2022, these limits increase: The phase-out begins at $129,000 for single filers and $214,000 for married filers. One way to think about asset location is simply as choosing where to invest so you will get the best tax deal.
Types of Funds for Asset Location Strategy
In a brokerage account, it makes sense to use the most tax-efficient funds. These might include municipal bond funds or funds that create little or no dividend income, such as certain exchange-traded funds (ETF), index funds, or growth stock funds. If the fund objective is “income” or “value,” the holdings of the mutual fund are most often stocks that produce income. For “income” or “value” funds, you’ll incur a tax bill if the fund is held in your brokerage account. A growth mutual fund most often holds stocks with growth objectives, which means the companies use their profits to reinvest in themselves rather than paying dividends to their investors.
Reasons to Use Asset Location
The main reason to use asset location is clear: Why lose money to taxes if you don’t need to? To keep taxes low on mutual funds, it helps to be smart about where you hold your assets. Taxes paid on gains can also be one of the biggest drags on a fund’s performance as an investment. To review, keep funds that produce income (such as most bond funds and stock funds with an income goal) in a tax-deferred account. An IRA or 401(k) will work well. Keep tax-efficient funds in a taxable account, such as an individual or joint brokerage account. Also, watch out for capital gains. If you expect to buy, sell, or exchange funds many times per year, try to do this more in your IRA or 401(k), where no capital gains taxes will result.
