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It may be time to revisit your asset location strategy.
Over time, it’s common to accumulate financial accounts without having a plan to coordinate and balance how they’re taxed—now and in the future. This could affect the value of your investments and undermine your efforts toward achieving your financial goals.
An asset location strategy takes into account the intended purpose of your assets and provides an analysis of how/if those assets should be ‘relocated’ or utilized in other accounts with different tax treatments. An asset location strategy can be as important as asset allocation, as it gives you a clear picture of all your assets.
Classifying your accounts and account types
The first step in developing an asset location strategy is to classify your various financial accounts. Most people own a mix of taxable accounts such as savings or brokerage accounts, tax-deferred accounts, such as workplace retirement plans and Individual Retirement Accounts (IRAs), and tax-never or tax-free accounts, which can include life insurance and donor-advised funds.
Using the table below, we categorized assets by account types that focus on the theme of "now," "later" and "never" for both the use and taxation of those assets.
|Assets you use to fund your everyday living expenses.||Assets that you have earmarked for future use such as retirement income, healthcare expenses, emergency savings and travel.||Assets that you do not anticipate needing to meet everyday living expenses – now or in the future. However, you want to maintain access to your ‘never money’ principal.|
|Emergency fund||Cash/Money Markets |
The flexibility of these accounts allows near-term goals to be met with little tax implication due to the minimal interest distributions.
|Long-term Care |
Tax-free income benefit should you need medical assistance.
|Saving for a home/renovations||CDs |
Current low-interest rates on short-term CDs and the known timing of interest distributions make these assets manageable from a tax perspective.
|Income protection||CDs |
If designated for retirement savings, consider holding these investments in tax-deferred accounts.
|Life Insurance |
Income tax-free death benefit proceeds can help replace income for beneficiaries.1
|College savings||529 College Savings Plans |
Specialized accounts for college savings that offer tax benefits when used for qualified education expenses.
|Retirement savings||Bond Mutual Funds |
Certain bond mutual funds tend to deliver most or all of their total returns as interest and dividends, taxable at ordinary income rates. Tax-deferred accounts can enable you to defer taxes to retirement when income levels are expected to be lower.
|Wealth accumulation||Individual Stocks/Bonds/Stock Mutual Funds |
These investments, when held for the long term, benefit from lower capital gains tax rates. The timing of taxation on gains can be controlled by the decision of when to sell these investments, making them a viable option for taxable accounts. Certain stock mutual funds, especially those with a high turnover rate, can help generate short- and long-term capital gains, generating a significant tax bill. Holding these types of assets in a tax-deferred account allows you to defer taxes.
|Legacy planning||Life Insurance |
Generally income tax-free death benefit proceeds create a legacy for heirs.
Looking to minimize the impact of taxes? Put asset location to work for you.
An effective tax minimization strategy begins by determining the proper location for your assets. Within your overall financial plan, a properly structured asset location strategy will minimize taxes to help you more efficiently achieve your goals.
If using an asset location strategy, you’ll place investments that could generate significant taxes into tax-advantaged accounts, and place lower-tax investment options into taxable accounts.
An example: Bank certificates of deposit (CDs) currently generate a small amount of interest. They’re best held in a taxable account. You’ll have to pay taxes on your CD earnings this year, but the amount is generally low enough that it won’t add much to your tax obligation.
On the other hand, a mutual fund that buys or sells stocks quite often may generate hefty short- and long-capital gains. Since these gains can generate significant taxes, you may be better off owning them inside a tax-deferred account such as your workplace retirement plan. When you eventually pay taxes on the account after you retire, you may be in a lower income-tax bracket.
You can also use accounts that bypass taxes altogether, such as life insurance policies, 529 college savings plans and donor-advised funds.
Creating an asset location strategy
Evaluate your investments using this four-step process:
Step one Identify your investment accounts; how and when they’ll be used and the taxation of each.
Step two Identify and prioritize your goals.
Step three Determine where to hold these accounts to achieve your goals.
Step four Consult with your tax advisor.
- List all your financial accounts; determine when they’ll be used and how much/when each is taxed. This should include your emergency savings, and accounts like college savings, retirement savings, life insurance, and any after-tax accounts. If you’re unsure when the accounts will be used and/or how the accounts are taxed, ask your financial advisor or the financial institution holding the account.
- Identify your goals and purpose for each account. Is one account intended as a rainy-day fund you can easily access? Which ones are earmarked for retirement? Do you hope to leave any accounts as inheritances for your children or as contributions to nonprofits?
- Consider the best “location” for each account—both to meet the financial goals you’ve laid out in Step 2 and to potentially reduce what you pay in taxes, now, later or never.
- Consult with your tax advisor. Before making any changes to your financial plan, it’s important to keep in mind that the tax status and tax benefits of your assets can change depending on how you use them and how and when the funds are accessed. There are generally strict rules for tax-deferred and tax-free accounts and they are generally not as liquid as taxable accounts.
Starting the conversation
1 Life insurance death benefit is generally received income tax free. Please see IRC Section 101(a)
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