Advisors who manage their clients' investments at the household level (across accounts) have an opportunity to create tax savings. Location optimization - holding specific types of investments within specific types of accounts - can minimize tax costs. Unfortunately, in today's market, advisors are getting it wrong.
Before I get into why, let's review the basics.
Location optimization organizes accounts into 3 types:
- Taxable: accounts such as joint accounts, trust accounts and personal accounts that are subject to state and federal tax as income and gains are recognized
- Tax Deferred: accounts that will be subject to ordinary tax rates at the time that amounts are withdrawn, such as IRAs, 401(k)s and annuities
- Tax Free: Roth IRAs (assuming held for 5 years and age 59-1/2, otherwise, only the basis is tax-free)
Applying location optimization strategy, investments should be divvied up as follows:
- Put investments with the highest expected returns in the Roth IRA. Since the Roth will never be taxed (see above), higher returning investments will get the greatest benefit.
- Put investments that produce regular ordinary income in tax deferred accounts. When distributions begin, they will be taxed at ordinary rates - the same as if held in a taxable account.
- Put appreciating investments, such as equities, in the taxable accounts. Since appreciation isn't taxed until sold, these assets effectively achieve tax deferral without being held in a tax deferred account. When eventually sold, the appreciation is taxed at capital gain rates.
Currently, most advisors applying location optimization hold U.S. corporate bonds in tax deferred accounts. This is not ideal in today's market environment. With the new surtax on investment income and municipal bonds often paying more than corporate bonds, advisors should be structuring portfolios differently. How? Take U.S. bond investments out of IRAs and, instead, hold municipal bonds in taxable accounts. Put other high yielding investments (such as real estate or international bonds) in tax deferred accounts.
When "repositioning" bonds in a client's portfolio, the advisor must consider tax costs. For example, a tax savvy advisor decides to reposition holdings by placing REITs in the IRA and municipal bonds in the taxable account (rather than holding taxable bonds in the IRA). Thus, the REITs must be sold in the taxable account. If the REIT holdings have appreciated, the client will recognize capital gains. Clearly, the tax cost on material short-term gains would outweigh the benefit of changing asset location. But, if it's a long-term gain, would the location savings be worth the tax bill? To answer this question, the advisor must consider:
- How material is the gain?
- Does the client have capital losses to offset and/or are they in a low tax bracket?
- How old is the client? (With a young investor, appreciation will likely be taxed at some point anyway. However, an older client might never pay tax on the appreciation. Thus, recognizing gain for an older client could make the tax cost too steep.)
- Will the reduction in the investment income surtax be greater than the tax on recognized gain?
Bottom line: To maximize tax benefits for clients, advisors should revisit their bond decisions, considering municipal bond yields vs. taxable yields as well as individual client circumstances.