Asset Location [Video]

Today we are going to talk about one of the silent killers of investment performance, taxes. Taxes are a fact of life and we can’t avoid them forever. However, we can be strategic about when they are incurred. Therefore, it doesn’t negatively affect our finances any more than necessary.

One thing I see a lot when reviewing investment statements is that people like to own mutual funds.  While they may be good mutual funds that perform well, they are not tax-efficient but are rather tax-inefficient.  What I mean by that is many mutual funds payout “capital gains distributions” at the end of the year. These are proceeds from the sale of stock and other assets by the fund’s managers.  These are then passed on to you the investment owner.  The gains are reported on a 1099 and picked up on your Tax Return as income, which you pay tax on.  It doesn’t matter whether you bought or sold it during the year, that tax burden is going to come to you whether you like it or not.  

Here’s an example: imagine a married couple who makes $150,000 a year and they also have a $250,000 portfolio.  Due to the investments they hold within their portfolio, it’s not uncommon for them to receive $10,000 capital gains distributions from the underlying mutual funds in any given year. The taxes they have to pay on the distribution is $1,500.  Now that may not sound like a lot of money, but when compounded year after year, it adds up!  

This example highlights the importance of a tax planning strategy called “Asset Location.” 

What that means is you want to make sure your tax-inefficient investments (ex. mutual funds) are held inside accounts like IRAs.  If that same mutual fund was instead owned within an IRA, the couple would be able to defer any income generated from their investments until funds are later withdrawn from the account in the future. Therefore, the $1,500 capital gain distribution in our example wouldn’t be taxable when received.

Conversely, any tax-efficient investments (ex. index funds) should be held within individual, joint or trusts which are considered taxable accounts.  Index funds, sometimes called passive funds, try to match indexes like S&P 500 or Dow Jones Industrial Average.  Since they don’t trade a lot, they also don’t generate a lot of capital gains, if ever.  

By being strategic about where your investments are held can end up saving you a lot of money over time. 

This is what we do for our clients and the portfolios that they entrust us to manage. We make sure their investments are not only appropriate to own, but are also located in the right kind of account. If you need help with your investments and you’re not really sure how to do this asset location strategy, then please call us.  We would be sure to help you with your investments.