Does it matter where investors save their money? Does it matter if their money is in a 401(k) plan account, an Individual Retirement Account (IRA), a Roth IRA, or a taxable investment account? Where assets are invested matters more than one would realize. Each of those account types is not created equal in the eyes of the Internal Revenue Code (IRC). 

There are three main tax categories where savings can be invested: tax-deferred, taxable, and tax-free. The tax-deferred investment category includes savings vehicles such as IRAs, 401(k) plans, pensions, 457(b) plans, and 403(b) plans, just to name a few. 

In these accounts, contributions are generally made using pre-tax dollars. This means the contributed money has not yet been taxed by any state, local, or federal governing body. Investors do not pay any tax on the earnings or contributions until they make withdrawals from the account. Generally, distributions from these accounts are taxed as ordinary income. 

The taxable category includes accounts in which investors make after-tax contributions. Unlike the tax-deferred accounts, these contributions have been taxed by state, local, and federal governments. In a taxable investment account, investors pay income tax on interest, dividends, and capital gains that the account realizes each year. Qualified dividends and long-term capital gains are taxed at preferred rates, a maximum of 20% (in 2021). Interest, nonqualified dividends, and short-term capital gains are taxed as ordinary income by applying rates as high as 37% in 2021. 

The final category is tax-free investments. These investment vehicles include Roth IRAs, Roth 401(k) plans, and (generally) insurance policies. Similar to taxable investment accounts, contributions to these accounts are made using after-tax dollars. However, unlike a taxable investment account, growth on the account is sheltered from ordinary income and capital gain taxes. Furthermore, if the appropriate rules are followed, the growth and distributions from these tax-free investment accounts may remain untaxed.

Why are there so many options? Why does this matter? Working with an advisor to find a mix of investments among the three different options is a worthwhile conversation. 

Every individual’s situation is different and should be separately evaluated; however, some advantages and disadvantages of each type of account are outlined below. 

Tax Deferred Account

Advantages 

  • There can be an income tax deduction or deferral in the year of contribution.
  • Capital gains and income generated in the account generally are not taxed until funds are distributed.
  • There are few income limitations for contributions to 401(k), 403(b), and 457(b) plans.
  • The account may be protected from creditors’ claims.

Disadvantages

  • All distributions are taxed as ordinary income, which can be as high as 37% (for 2021).
  • The Internal Revenue Service (IRS) requires minimum distributions when the account owner reaches age 70½ (for those born before July 1, 1949, or age 72 for those born after June 30, 1949, if age 70½ attained after 2019).
  • The tax-cost basis in tax-deferred account assets like retirement plans and IRAs do not receive an adjustment to fair market value at the death of the account owner; and, for accounts of owners who die after December 31, 2019, most (non-spouse) heirs must fully distribute (and pay tax on) such accounts by December 31 of the tenth year following the owner’s death.
  • There is an income limitation threshold on the deductibility of IRA contributions.
  • There are contribution limits for IRA, 401(k), 403(b), and 457(b) plans.

Taxable Account

Advantages

  • Qualified dividends and long-term capital gains in the account have preferred tax rates capped at 20% for 2021.
  • When the account holder dies, the assets in the account will receive a step-up in basis for the next generation.
  • There are no rules regarding when the money can be accessed for use.

Disadvantages

  • There is no tax shelter on the assets in the account. All interest, dividends, and capital gains that are created in the account are currently taxable.
  • Unless the account is protected in a spendthrift trust, it may be subject to creditors’ claims. 

Tax Free Accounts

Advantages

  • Growth in the account generally is not taxed so long as the laws making the account tax-free and the provisions of the account are followed.
  • Distributions from the account, including the capital gains, may be tax-free.
  • There are no required minimum distributions (RMDs) when the account owner reaches age 70½ or age 72, as applicable, other than from Roth 401(k)s.
  • When an individual inherits the account, the distributions remain tax-free. 

Disadvantages

  • Money is contributed after tax, so there is no current-year deduction for contributions.
  • There is an income limitation threshold with respect to contributions to Roth IRA accounts.
  • There are limits with respect to the amount that can be contributed to a Roth IRA and a Roth 401(k) account.
  • Life insurance may be expensive, depending on the insured’s current health, age, and other factors.


Asset Allocation

So what about asset allocation and asset location? Which type of asset should be held in each of these type accounts? This is where asset location comes into the conversation. 

Asset location is a tax-minimizing strategy that looks to determine which type of investments should be held in tax-deferred and tax-free accounts versus which type of investments should be held in taxable accounts. 
 
This strategy should also take into consideration other factors relevant to the investor and assets, such as tax law changes, holding periods, and an investor’s goals and objectives. 
 
This strategy is not a replacement for asset allocation, which considers an investor’s overall risk appetite and desired mix of stocks, bonds, and alternative investments. Planning for asset location should be completed after an investor’s asset allocation has been determined. For instance, if a client’s risk tolerance leads them to a portfolio with a mix of 60% stocks and 40% bonds (called a balanced portfolio), this does not mean that each account has to be allocated that way. Multiple accounts can be weighted in such a manner that their combined balances achieve the desired asset allocation in the most tax-efficient way. As a result, the balanced portfolio would be obtained by coordination across all taxable, tax-deferred, and tax-free accounts, rather than in each individual account. 

In tax-deferred accounts, where taxes are paid at ordinary income rates as money is withdrawn from the account, capital gains and qualified dividends lose the benefit of their preferential tax rate treatment. Ordinary income rates can be as high as 37% (2021 rates), whereas long-term capital gains and qualified dividends from a taxable account have preferred tax rates that are no more than 20% (2021 rates). Holding stocks in a taxable account allows the investor to take advantage of the preferential tax treatment that applies capital gains tax rates to qualified dividends and long-term capital gains.

Investments that create interest income and a regular cash flow, such as notes, bonds (except for interest derived from certain municipal bonds) and real estate investment trusts (REITS), are taxed as ordinary income, no matter what type of investment account they are held in, at rates up to 37% (for 2021). Due to the tax treatment of these funds, investors may want to shelter the income from such assets in a tax-deferred account and generally delay paying tax until the money is withdrawn from the account. If the taxes weren’t sheltered and instead were held in a taxable account, the income from these types of investments would be taxed each year as ordinary income. Distributions from a tax-deferred account are taxed as ordinary income, no matter what type of funds it holds. As such, it may be advantageous to hold taxable bonds and REITs in a tax-deferred account where the yearly income is sheltered from taxes and the distributions are taxed in the same manner as ordinary income. 

Investments that typically carry a higher tax bill such as hedge funds, master limited partnerships (MLPs), an investment overseas, or investments that have the potential to quickly grow in value may be positioned in an investment account that is non-taxable. In these accounts, investments are given the opportunity to grow without the hindrance of the tax cost that is normally imposed upon them. For example, if a hedge fund or MLP is in a Roth IRA or a life insurance contract, that investment will be allowed to grow each and every year without having to pay a potentially large tax bill.[1] 

Additionally, distributions may be tax-free if the special tax laws applicable to the asset or the account are followed. This could allow an investor to have exposure to these types of investments and diversify their holdings while limiting tax cost. 

For illustrative purposes, assume that stock assets are allocated to a taxable account and taxable bond assets are allocated to a tax-deferred account. Based on these parameters, see how the proper asset location strategy benefits the investor and heirs:

  • Tax-deferred accounts generally must take RMDs at age 70½ (if born before July 1, 1949) or age 72 (if born after June 30, 1949), which would then come from an account with less risk and less potential growth.
  • In addition, the estate heirs could inherit a smaller tax-deferred account due to bonds having a lower growth potential. This may be beneficial because when accounts of owners who die after December 31, 2019 are inherited, most (nonspouse) heirs must fully distribute (and pay ordinary income tax on) such accounts by December 31 of the tenth year following the owner’s death from a smaller balance. 
  • Conversely, the taxable account could grow to a larger amount, considering the growth potential of stocks; those assets would receive a tax-cost basis adjustment to fair market value when passed at the account owner’s death to heirs. 
  • Lastly, a tax-free account can be extremely beneficial to inherit because when these funds are passed on to the investor’s heirs at the account owner’s death, income tax is not paid and the account may retain its tax-free nature for a period of time (for deaths after 2019, generally up to 10 years, unless an exception applies). While the tax-cost basis of a tax-free asset does not receive an adjustment to fair market value at the account owner’s death, the heirs generally are not required to pay income taxes on distributions from the account.

The table below provides a visualization of where assets might be placed in the types of accounts discussed above.

Table 1: Potential Tax Implications of Asset Placement

  Tax Implications Tax-Deferred Tax-Free Taxable
Municipal Securities and Mutual Funds (Tax-Free) Exempt      X
Equity Securities (Long Term)  Taxed at long-term capital gains rates X X X
Index Funds/Exchange-Traded Funds (excluding REITs)  Taxed at long-term capital gains rates  X X X
Mutual Funds and Managed Accounts (Tax-Managed)  Taxed at long-term capital gains rates      X
REITs Taxed at ordinary income rates  X X  
Stock Mutual Funds  Taxed at ordinary income rates  X X  
Taxable Bonds and Bond Funds  Taxed at ordinary income rates  X X  

Source: PNC

In short, asset location has the potential to benefit an investor’s strategy and goals, but it can also hinder a strategy or even prevent an investor from reaching those goals if not properly managed.

Taxable, tax-deferred, and tax-free accounts all have advantages and disadvantages, and may be suitable when used in tandem for your portfolio. 

To discuss the impact of asset location on your investments and goals, contact your advisor today.