Your 2017 tax bill depends as
much on asset location as it does on asset allocation.
Asset allocation determines where
you're investing your money and how those investments are balanced. Asset
location, however, takes it a step further by putting investments that generate
huge amounts of ordinary income into tax-deferred or tax-free accounts. It also
places investments taxed at a lower capital-gains rate into taxable accounts.
The overall goal is to minimize
taxes while protecting asset growth.
"Most
asset-location strategies that work today will work just as well in 2018
under almost any scenario, though you may need to make some adjustments,"
says Thomas Walsh, certified financial planner with Palisades Hudson Financial
Group.
So how does it work? First, you
have to stop looking at your investments as separate entities and view them all
as one big portfolio. Your IRA, Roth IRA, SEP IRA, profit-sharing plan, 401(k)
or 403(b) should all be considered options for mixing and matching your
investments.
Next, determine which of your
investments within those accounts are taxed at the highest rates. If some of
your assets are in a real estate investment trust (REIT), for example, they're
generating lots of ordinary income and tax liability. Investors can minimize
that damage by placing REITs in a tax-deferred retirement plan like a 401(k) or
IRA. Taxable bonds have similar issues, but folks who need access to them for
more immediate needs can spread them between taxable accounts like Roth IRAs
and tax-deferred retirement funds. If your tax bracket is high enough, however,
tax-free municipal bonds in taxable accounts may be a better alternative.
"That way, you can get tax
efficiency while meeting your allocation to low-risk investments," Walsh
says.
Stocks are another story.
Investors will see more gains through capital appreciation than via dividends
over the long term. If you hold onto those equities for at least a year, you'll
get the lower long-term capital gains rate when you sell them. While stocks
will yield larger capital gains than bonds in the long run, investors can't get
the lower capital gains rate in tax-deferred accounts. With all withdrawals
from those kind of retirement accounts subject to ordinary income tax,
investors are better off placing stocks and equity funds in taxable accounts
like a Roth IRA.
Meanwhile, qualified stock
dividends are taxed at a lower federal rate: Between 0% and 23.8% for 2017.
"People in the 15% tax
bracket today, for example, pay 15% federal income tax on bond and bank
interest but absolutely nothing on qualified stock dividends," Walsh says,
noting that even recent tax reform won't kill that tax break in 2018 and
beyond.
However, there isn't one broad
rule about where to place your stocks. Actively managed stock mutual funds with
high turnover pay huge distributions at the end of the year. If investors would
rather hold off on paying those taxes until they are in a lower tax bracket,
they should stash those mutual funds in tax-deferred or tax-free accounts.
Index funds and international
funds and equities, meanwhile, should be held in taxable accounts. The
international stocks and funds withhold foreign taxes on dividends and allow
investors to claim a foreign tax credit on their return. Index funds,
meanwhile, pay small distributions and have low turnover.
Investors should keep in mind
that any annual tax savings from asset location will likely be small and may
not make much of an impact on your annual tax bill. However, those moves will
help increase your after-tax investment returns year by year.
"Over decades, these small
amounts compound and can really add up," Walsh says.
Don't forget to mind your asset
allocations as well. Advisors regularly suggest rebalancing your portfolio to
ensure that you aren't heavily invested in assets that have done well
(equities, for example), and under-invested in assets that have fared poorly.
By selling high and buying low, you control future risk and keep your desired
returns on track.
Just don't tinker around with
your portfolio for the sake of doing so. Finance site NerdWallet found that 12%
of U.S. investors would change their asset allocation immediate after the
Federal Reserve raises rates. That's the absolute wrong move for a long-term
investor.
"Instead of toying with your
investments or trying to chase a higher rate or better return," says
Arielle O'Shea, NerdWallet investing and retirement specialist, "control
the things you can control: how much you're spending — which directly
influences how much you have available to save and invest — and whether you're
on track to reach your investment goals."
Click
here for the original article from The Street.
This
article is commentary by an independent contributor. At the time of
publication, the author held no positions in the stocks mentioned.