By Allen Giese, CLU®, ChFC®, ChSNC®

Not all items in your investment portfolio are taxed the same, and understanding this can lead to lower overall tax payments in personal investing. Some investments produce more income, dividends, and interest, which is taxed as ordinary income. Other items produce very little income but have historically higher growth or gains, and those gains (if held more than a year) are taxed using the capital gains tax table, which is more favorable than the ordinary income tax table.

Recognizing these differences allows you to take advantage of them when it comes time to choosing whether to place an investment into your taxable portfolio (like a brokerage account or revocable trust) or your pre-tax portfolio [like an IRA or 401(k)].

Because the pre-tax portfolio shields income from taxation and a taxable portfolio doesn’t, it makes sense to place items that produce high income into your IRA. This would typically include fixed income, bonds, and real estate investment trusts (REITs). Investments that have very little income, dividends, and interest should ideally be concentrated in the taxable portfolio. These investments would include most equities.

As an example, let’s assume an investor has $500,000, with $300,000 in an IRA and $200,000 in a brokerage account. We’ll assume this investor decided to allocate 60% to equities and 40% to fixed income. That means, across both accounts, $200,000 will be allocated to fixed income.

Utilizing an asset location strategy to minimize taxes, this investor would place all the fixed income in the IRA ($200,000), leaving $100,000 left over to invest in equities in that IRA. The brokerage account would then be 100% invested in equities. If you look at both accounts together, the allocation would be right on target, or 60/40.

You can see right away that a couple of things will happen going forward. First, it’s likely that the performance between the two accounts will be very different. One could reasonably presume that since equities have a higher expected return than fixed income, the brokerage account will grow at a faster rate, and the IRA will soon lag behind. That’s all right! We look at both accounts as if they were one.

At some point, if the brokerage account outpaces the IRA enough, this investor will have to start including fixed income into the brokerage account, and the IRA will contain no equities. Again, that’s OK. You want to consider the two accounts as one.

This strategy gives the investor an advantage once they have reached the age for required minimum distributions (72-75 depending on the year of birth). Since the IRA portion of the investment is smaller due to lower expected returns in fixed income, the RMD will be correspondingly lower as well. RMDs are taxed as ordinary income, and since the investor will take smaller RMDs, they’ll pay lower taxes.

Another advantage is for heirs. Inheriting a brokerage account and an IRA at equal value is a very different experience. First, when passed to a beneficiary who isn’t the spouse, the IRA must be liquidated within 10 years. When distributed, it is taxed as ordinary income.

Suppose you have an heir in their peak earning years who inherits your IRA. They will be required to completely empty the IRA within 10 years, taking all that income ON TOP of whatever earned income they already have. It’s not unusual to see an heir forced into higher and higher tax brackets.

If that same heir inherited a brokerage account, the brokerage account gets a “step-up” in tax basis, effectively wiping out any taxable gains as of the date of death. In essence, they inherit the brokerage account free and clear of taxes and will be responsible only for capital gains taxes on the growth going forward.

An asset location strategy isn’t for everyone, but when it lines up right, it can be an effective technique to reduce taxes from investments over the long haul.

Questions about your situation? Give us a call!