Asset Location

Asset Location

If I were to show you a picture of a house, would you be able to tell me about how much that house is worth? Of course not. Why? Every one of you probably responded in your head, “Well it depends on where the house is located.” Exactly!

In real estate, location is arguably the most important decision to make. The same exact house could be worth $750,000 in San Francisco and $150,000 in the middle of Kansas. This is something that everyone understands.

Unfortunately, most people don’t understand that asset location can be just as important.

Asset location refers to what type of accounts your investments are held in. You can own investments in taxable brokerage accounts, retirement accounts, insurance products, college savings plans, etc. The reason this decision is so important is because of tax consequences. An investment in your 401k isn’t taxed until you take the money out. Whereas, an investment in a normal brokerage account is taxed immediately.

I will go over the standard investment accounts and talk about what investments fit best for them. I will discuss this assuming you own investments in each type of account and have the option to pick your investments in them. Some of this may not pertain to your situation now, but it may help you in the future.

· Taxable Accounts – Immediate taxation on your investments.

o   Good – Stocks, Tax-Free Bonds, ETF’s. Stocks are taxed at a lower rate than ordinary income tax if held more than a year. Dividends that are paid will also be taxed at a lower rate. Tax-free bonds are good choices as well. These generally pay a lower interest, but the payments are free from federal tax. ETF’s are great in taxable accounts because they work the same way stocks do. They pay dividends and are taxed when you sell the shares.

o   Bad – Taxable Bonds, Mutual Funds, REITs – Taxable bonds pay interest monthly or quarterly. This interest is taxed as ordinary income. These should be the last investment made in a taxable account. Mutual Funds distribute capital gains and dividends throughout the year. These can be at ordinary income tax rates. If you must own mutual funds in your taxable account, try to own passive funds that do not trade as frequently. REITs (Real Estate Investment Trusts) are required to pay out a high percentage of profits. These payouts are taxed at your ordinary income rate instead of the lower dividend rate.

· Traditional Retirement Accounts (401k, 403b, IRAs) – Taxed at ordinary rate when withdrawn.

o   Good – Mutual Funds, Taxable Bonds, REITs – All the negatives from the taxable account make these accounts the best place for investments that give you income at ordinary tax rates. The goal is that your ordinary rate will be lower during retirement when you withdraw from these accounts.

o   Bad – Tax Free Bonds & Annuities – Tax free bonds usually pay less interest than regular bonds. Since the interest is tax free, it doesn’t make sense holding in these accounts because you will be taxed on the money when you withdraw from the account. Annuities are usually a bad investment due to the outrageous fees. If you do find one that fits in your investment mix, don’t hold it in an IRA. Annuities allow for tax deferred growth on their own similar to traditional retirement accounts. It would be like standing inside your house to avoid getting rained on, but holding an umbrella over your head as well.

· Roth Retirement Accounts – Tax free growth on withdrawals over 59.5 years of age

o   Good – Almost all investments. Roth accounts are never taxed if withdrawn properly. These are the investments that you hope have the most growth and highest payout so that you can keep it all.

o   Bad – Tax Free Bonds & Annuities – See comments above.

Remember, you may not be able to align your assets perfectly between these accounts. Employer retirement plans don’t always offer the best variety of investments. You may still be trying to max out your retirement accounts before you open a taxable account. That is perfectly fine. Just keep this in mind as your accounts begin to grow and you diversify more. These changes can add a percentage or more to your investment return which could be over $1 Million difference depending on your age. That could mean the difference in retiring with comfort or always worried if your money will run out.

Mike Zeiter, CPA/PFS

Retirement Accounts

Retirement Accounts