Are Your Investments Managed Well to Minimize Taxes?

Post Written by: Scott D. Michael, CFP®, AIF®

Different types of accounts will have different results.

Location, location, location. We’ve all heard that phrase when purchasing a home. Did you know: the same concept applies to your finances and investments?

The investments you have are important, but where you have them is critical, too.

When your assets reside in the right place, you can help minimize taxes. Working with a financial advisor with CPAs on staff and years of experience in tax planning strategy can closely manage this for you. Without such careful attention to where your assets are held you could be paying more taxes than you need to.

Different Types of Accounts

As your wealth grows, you will likely accumulate significant assets in your retirement and other accounts over time. Different types of accounts have different effects on your wealth and taxes.

Retirement accounts include some restrictions in how the funds can be used, so other account types may also be recommended. In some scenarios, you may be placing capital into non-retirement-restricted accounts, making the amount there more accessible, should you need it.

Within retirement account types, Domani Wealth may also recommend using a Roth account if you’re eligible. Roth accounts allow you to contribute after-tax dollars, with all withdrawals generally being completed free from tax.

This is useful information, of course, and can help you use the tax code to your benefit.

Unfortunately, that’s not the full picture. What may not be as clear is the importance of putting the right investment in the right place, often referred to as asset location. It’s not as simple as having general diversified account types, or just knowing what accounts you have – the strategy of how you use each type is key to minimize taxes.

What Does Asset Location Mean?

There are three types of accounts from a tax perspective:

  1. Taxable Accounts (regular, non-retirement investment or asset-holding accounts)
  2. Tax-Deferred Accounts (Retirement accounts such as traditional IRAs, 401(k)s and similar plans)
  3. Tax-Exempt Accounts (Can be both exclusively for retirement, such as Roth IRAs, Roth 401(k)s and similar plans, and other types of accounts, such as Health Savings Accounts)

Asset location refers to the decision to put particular funds into one of these three account types. Working closely with a qualified advisor can help provide you with valuable guidance; this will impact your taxes and the timing of those tax payments.

Asset Location is Within Your Control

You can’t change the tax code or what accounts you may qualify to use, but you can adjust your holdings so you get the best tax benefits available in those accounts. By optimizing for asset location, you can potentially reduce your tax bill and minimize taxes. Once you retire, asset location can also help you save money as you begin to draw income. This can help your assets last longer in retirement.

Asset Location in Action: An Example

Maria owns an actively managed growth fund in a taxable portfolio account. She’s held it for several years, and it has performed well for her, so she has started to buy that fund in her other accounts as well. Now, she holds that fund in her regular taxable portfolio account, her Roth IRA, and her traditional IRA, along with her other investments.

While that seems simple and smart, it’s not as positive as she might think – where Maria started may not have been the best. Actively managed mutual funds can involve frequent transactions that create higher capital gains. When investing in mutual funds, the investor has no control over the timing of taxable events like they would with individual stocks, where a financial advisor can time sales to best manage tax liability.

For this particular mutual fund, holding it in that taxable account is probably increasing Maria’s tax bill whether she realizes it or not, due to the nature of frequent trades. A trusted and qualified financial advisor would have discussed asset location with Maria, and may have suggested that she hold this particular mutual fund in her retirement accounts only – rather than the taxable portfolio account she holds it in now.

That way, Maria has tax deferral on her side with her traditional IRA. Then with her Roth, earnings and gains are tax-free, so that’s even better. Removing the fund from her taxable portfolio account at this point may generate tax liability if it is sold at a gain. Therefore, a thoughtful plan sensitive to taxes would need to be carefully developed for its removal.

General Guidelines for Asset Location

Because tax law can change, asset location best practices can change, too. Some general guidelines to keep in mind when determining where to position investments in different types of accounts:

  • Actively managed funds can have frequent transactions that may result in higher capital gains taxes.
  • Taxable bonds and real estate investment trusts (REITs) produce ordinary income not usually subject to more favorable tax rates.

Holding these types of investments in retirement accounts (either tax-deferred or tax-exempt) might help minimize your current tax liability.

On the other hand, there are other investments that either generate fewer taxable events or already receive favorable tax treatment in the current tax code:

  • Dividends typically receive favorable tax treatment.
  • Index funds often produce fewer capital gains distributions.

Because these usually generate less income and capital gains taxes or already have tax benefits working in their favor, these holdings are generally more suitable for taxable accounts.

What about municipal bonds? As you may know, municipal bonds generally pay interest that is not subject to federal tax. The interest might also be exempt from state tax, depending on the particular bond issue. Because of this favorable tax status, municipal bonds are usually best suited for a fully taxable account. Otherwise, you risk losing out on these valuable tax benefits.

These are just a few examples. As you can probably see, keeping your investments in the right place requires planning and familiarity with the current tax code – best suited for a financial advisor with background in tax strategy and a firm with CPAs on staff.

The Health Savings Account Triple-Tax-Triumph

A Health Savings Account, or “HSA”, tied to a health insurance plan that offers high deductibles, can be overlooked when considering tax strategy and account types.  These accounts can provide a significant tax saving opportunity for the following reasons:

First, you contribute to an HSA using pre-tax funds, either withheld from a paycheck or deductible in calculating adjusted gross income. This decreases taxable income the year you make those contributions, reducing your tax liability. (Please note that annual contribution limits apply.)

Secondly, if funds are used from this account for qualified medical expenses, they can be used without paying taxes on the withdrawn amounts. Funds in the account can be kept in it year to year, unlike a Flexible Savings Account, which must be used up at calendar year end.

Lastly, any investments the HSA holds can increase in size tax-free.

Not Just Where; When Matters Too

Because of the complexity of the tax code, other considerations apply as well. Often, it’s a good strategy to pay taxes now if you think tax rates will rise in the future. Historically, U.S. taxes are quite low, so if you expect your assets to grow, you may be better off paying taxes sooner rather than later.

As you might have guessed, that’s a good argument to utilize a Roth account if you’re eligible for one or to convert another retirement account to a Roth account if that’s possible in your situation. A financial advisor will be able to discuss your goals and arrange the best fit of account types to help you minimize taxes on the way to realizing your dreams!

Conclusion

Tax knowledge is essential to financial planning and portfolio strategy. In today’s uncertain landscape, increasing your existing investments’ tax efficiency is a savvy method to minimize taxes without taking on additional risk.

It’s helpful to work with a financial advisor who brings investment and tax expertise together to help optimize your entire financial life. That way, the ultimate goal is always to minimize taxes whenever possible through strategies like these. It’s a technique that may seem complex and negligible; however, over time it can make an enormous impact.

If you’d like to discuss approaches to lessening taxes or methods to manage portfolios while maximizing your financial strategy, Domani Wealth has a whole team of wealth and investment professionals to help! Our 25+ years of experience and deep credentials – not to mention our passion for all the nitty gritty details of numbers – help ensure our clients feel confident and comfortable with their financial picture. Give us a call at 855-855-5545 or email info@domaniwealth.com to start a conversation!

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