While most clients have an understanding of asset allocation, many are not aware of the term asset location. This refers to how client assets are held based on the tax characteristic of the underlying account — taxable, tax deferred, and tax free. Since taxes always pose a risk to clients’ wealth and the prospect exists for significantly higher taxes in the future, there is an opportunity for financial advisors to provide value to clients by addressing tax efficiency. In what types of accounts does it make sense to hold certain types of assets? Here are some considerations:
Taxable accounts — Take advantage of the 15% tax rate on long-term capital gains and qualified dividends by holding assets such as dividend-paying stocks and mutual funds within taxable accounts. Holding equities within taxable accounts also provides an opportunity to defer capital gains and tax advantage of capital losses through strategic buy/sell decisions. Also, if a legacy objective exists, it might make sense to hold appreciated stocks, mutual funds, or other capital assets within a taxable account to take advantage of full step-up in cost basis at the death of the asset holder.
Tax-deferred accounts — Since these accounts are generally taxed at ordinary income rates, they hold a larger percentage of income-producing assets such as fixed-income investments and real estate. One exception might be appreciated company stock held within an ERISA retirement plan if eventually the client wants to retain the option of utilizing the NUA strategy when distributing the company stock from the plan at retirement.
Tax-free accounts — Assets that may appreciate rapidly may make sense to hold in a tax-free account such as a Roth IRA. Another relevant asset would be actively traded stocks that may generate frequent short-term capital gains. Lastly, if a legacy objective exists, holding appreciated assets within a Roth IRA can make sense since neither the account owner nor the beneficiary spouse (assuming the spouse transfers ownership to him/herself after the death of the account owner) have to take RMDs leaving a larger tax-free legacy to heirs.
Introducing this type of discussion with clients or prospects can help them better insulate their portfolios from taxes and may lead to consolidation of certain accounts such as IRAs and retirement plans.
For more information, download our Developing a tax-smart retirement income strategy investor education piece.