Asset Location for Tax Efficiency: What You Need to Know

Many investors spend more time worrying about what securities to own and relatively little time considering where to own those securities. Specifically, they haven’t considered whether the security should be held in their IRA (or other pre-tax account) or if it should be held in their taxable account (after-tax account). This can be an expensive mistake given today’s tax environment.

High net-worth investors with large portfolios should locate more of their growth-oriented securities (stocks) in after-tax accounts and more of their income-oriented securities (bonds) in pre-tax accounts. The goal is to slow the growth of the IRA and ramp up the growth of the after-tax account. Here are three reasons why this makes sense:

1. Tax-Friendly Withdrawals: For most investors, withdrawals from after-tax accounts are much more tax-friendly than withdrawals from pre-tax accounts. Recall that withdrawals from pre-tax IRAs/401ks are taxed as ordinary income. In contrast, withdrawals from after tax accounts are not taxed, per se. Rather the activity inside the after-tax account may be taxable. Stock sales may generate taxable capital gains and most dividends are also taxable. In most cases however, when transactions in after-tax accounts create a tax bill, the applicable tax rate is more favorable than ordinary income tax rates. In an after-tax account, investors can also engage in tax-loss harvesting to offset gains and of course municipal bonds can be owned for tax-free or partially tax-free income. In short, an after-tax account is a more favorable place to have money . . . it spends more tax-efficiently. Said another way, a dollar taken from an after-tax account nets you more than a dollar taken from a pre-tax account.
2. Step-up at Death: Given a choice, one should choose to die with a large after-tax account and a small IRA rather than the opposite configuration. Under current law, one’s heirs receive a step-up in the cost basis on all securities in an after-tax account. Heirs can inherit a stock portfolio today and sell all the stocks the next day and pay no capital gain tax. In contrast, if one’s heirs inherit an IRA, there is no getting around the eventual income tax that will be due as the money is withdrawn from the IRA. And the IRA withdrawals are taxed at ordinary income rates. So we want a small IRA and a large after-tax account if we have a choice.
3. Required Distributions: After we reach age 70.5, the government requires that we take a distribution from our IRA each year. For married couples, the amount of the required draw in the first year is approximately 1/27th of the account balance. The fraction grows larger as we age. Owners of large IRAs are therefore facing a significant amount of unavoidable income in retirement and this unstoppable income will be taxed as ordinary income. For example, the required distribution on an IRA worth $4 million is about $150,000 for someone aged 70.5. That income plus social security, dividends, etc. will almost guarantee that the taxpayer is in one of the higher tax brackets. The larger the IRA, the larger this required distribution. So our goal should be to slow the growth of the IRA, thus minimizing the amount of the required distribution. Wouldn’t it be nice to take large, lightly-taxed withdrawals from our growing, after-tax account and small, heavily-taxed required distributions from our shrinking IRA?

For the reasons listed above, investors should locate more of their growth holdings (stocks) in after-tax accounts and more of their income holdings (bonds) in IRAs. Note that the goal is not to slow the growth of the overall portfolio. We want the overall portfolio to grow at the same rate. We simply want that growth to occur in our after-tax account and not in our IRA.

We hope this is helpful. Please let us know if you would like to discuss this strategy.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.