RETURNS THAT MATTER

“…nothing is certain except death and taxes.” Benjamin Franklin’s words still ring true, over 230 years later.

Asset allocation – the percentage invested in stocks, bonds, and other asset classes – rightly receives a lot of investor attention. Asset location, on the other hand, is often overlooked. If you pay taxes on investment income, that could be a costly mistake.

The government is a (sometimes) silent partner in our investment portfolios. It isn’t a matter of if*, but when they will receive their piece of the pie.

*Not talking to you, tax-exempt plans and investors…

Fortunately, there are ways we can minimize the impact of taxes. And the only returns that really matter are those that we keep.

HOW IS IT TAXED

It may help to think of taxes along two lines:

1. Type of account, and

2. Nature of the income or earnings from the investment.

What type of account is it?

When thinking about account types, a simple grocery analogy may help. Some food belongs in the refrigerator, other foods belong in the freezer, and the rest probably belongs in the pantry. You’d never store your ice cream on the shelf next to a bag of Doritos.

Investments and account types can be thought of in a similar vein, with three primary buckets subject to different tax treatment.

1. Taxable – One of the more common examples is an old-fashioned brokerage account. Interest, dividends, and gains are taxed in the year they’re earned, at the appropriate tax rate. In exchange for sheltering from current taxes, investors receive incredible flexibility.

2. Tax-deferred – this includes things like a 401(k), a traditional IRA, or an annuity. Earnings avoid taxation in the current year, growing tax deferred. However, withdrawals above the basis are taxed as ordinary income. In many cases, 401(k) contributions are made with pre-tax dollars, so ALL withdrawals will be considered ordinary income for tax purposes. Not great. Remember tax rates on ordinary income are among the highest you’ll pay.

3. Tax-free – my favorite bucket is the tax-free bucket. Think of Roth IRAs, HSAs, and even 529 accounts. Contributions grow tax deferred and can be withdrawn tax-free, assuming all criteria have been met. Pretty sweet deal. And, if you make too much money to contribute to a Roth IRA, you can read about the backdoor Roth IRA strategy here.

Back to the buckets in a moment. Next, let’s consider the investments themselves.

How are the investment’s earnings taxed?

For high-income individuals and families, ordinary income is generally the worst type of income from a tax perspective. Income from some investments like corporate bonds or U.S. Treasury bonds is taxed as ordinary income. Qualified dividends from stocks receive preferential tax treatment, as do capital gains on investments held longer than a year. The IRS outlines what dividends are not considered qualified here.

The difference in tax treatment can be stark. Consider a high-income married couple earning $500,000 per year who files jointly. The marginal federal tax rate on ordinary income for this couple is 35%. Long-term capital gains and qualified dividends are taxed at just 15%. Yes, when it comes to taxes, lower is better. Owning investments whose returns are primarily driven by ordinary income (looking at you, taxable bonds) in a taxable brokerage account is not ideal. Tax-deferred accounts like traditional IRAs and 401(k) might make much more sense, considering the withdrawals will be taxed as ordinary income anyway. Stocks on the other hand typically generate returns through dividends and capital gain, which could make them much more attractive options for those taxable dollars.

Investment structures and improvements in technology give taxable investors excellent options for dollars in traditional brokerage accounts. These accounts provide no tax shelter at all. Income and gains are taxed each year. However, structures like ETFs give us a great deal of control over when we realize gains and losses, thereby controlling timing of tax liabilities. Index ETFs like those that track the S&P 500 are increasingly being joined by actively managed ETFs who aim to outperform those indexes over long periods of time. Custom indexing (aka direct indexing or personalized indexing) continues to grow in popularity, which combines index-like investing with regular tax-loss harvesting, attempting to deliver a better after-tax return than alternatives. Finally, tax-free municipal bonds can make tons of sense for high-income individuals and families with significant taxable assets.

Will It Grow?

Entrepreneur Peter Thiel famously used asset location to grow a $2,000 investment into a $5 billion fortune by investing in very high-growth private startups in his Roth IRA, thereby avoiding tax on all investment gains. While we may not have the same access to uber-successful private businesses like Thiel, we can apply a similar investment framework.

When we think about asset location, the concept is very simple: keep more of what we earn. Avoid paying tax on investments expected to earn higher returns, and watch the after-tax accumulation of money grow larger.

Imagine two investments. You will own either for 20 years and have $100,000 to invest. Investment A is expected to grow at 4% per year, and the expected return for Investment B is 8%.

Investment A will grow to $219,112. Investment B will be worth $466,096. The gains are $119,112 and $366,096, respectively. Would you prefer to pay tax on smaller gains or larger gains? Again, I think the answer is clear.

Thoughtful asset location attempts to protect gains from taxes by placing investments with higher expected returns in account types that provide the greatest after-tax benefit.

Summary

Asset location can have a meaningful impact on the long-term returns that matter most – the after-tax returns. For many business owners and high-earning individuals and families, taxes will represent your largest single expense. Working to position investments so that you’re likely to keep more of what you earn can have a significant impact on growing and protecting your family’s wealth over time.

Interested in discussing your situation? Email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversations.

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