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Tax management

Asset location strategies

January 27, 2022 - 4 min read

While numerous studies have shown that asset allocation accounts for the majority of return differences across investment portfolios, asset location can play a critical role in enhancing after-tax returns, especially for higher income investors. Asset classes generate various types of income (e.g. qualified dividends, non-qualified dividends, taxable interest, short-term capital gains and long-term capital gains), and each type receives different tax treatment.

Investors who use a balanced mix of equity and fixed income investments can gain the most benefit from an asset location strategy. Using the same asset allocation in taxable, non-taxable and tax-deferred accounts ignores the benefits of properly placing securities in the type of account that will assure the best after-tax return.

Sorting investments into accounts to maximize after-tax return is often called active asset location. This approach requires thinking holistically about all of your investments and account types, including taxable brokerage accounts as well as tax-sheltered accounts such as 401(k)s, 403(b)s, IRAs and Health Savings Accounts. The higher the marginal income tax rate an investor pays, the larger the potential benefits of active asset location become. However, tax optimization should not override risk tolerance or an investor’s liquidity needs.

Sorting investments by tax efficiency

Individual equities and equity index-based ETFs are generally relatively tax efficient if bought and held for at least a year. Capital gains taxes due on the sale of equities held longer than a year range from 0% to 23.8%, depending on an investor’s taxable income. Long-term gains and qualified dividends on assets held in taxable accounts receive preferential tax rates (generally 0% or 15% for most investors). Additionally, due to the higher volatility of equities, this presents an opportunity to loss harvest, in a sense letting the government shoulder some of the downside risk.

Index funds that invest in foreign equities are especially well-suited for taxable accounts because investors can receive a tax credit for foreign withholding taxes on dividends – but only if they are held in a taxable account. If equities are held in a taxable account until death, heirs receive a step-up in cost basis, thus potentially avoiding gains altogether. Charitably inclined investors can donate appreciated shares instead of cash, avoiding tax on the capital gains, but receiving a tax deduction on the full amount gifted. As a result, it may generally make sense to concentrate equities in taxable accounts.

Income generators in tax-advantaged accounts

Taxable bonds and bond funds (both active and passive) are not very tax efficient because they generate a large portion of returns from coupon payments which are taxed as ordinary income. This is especially true for high yield and emerging market debt due to their higher coupons. Ordinary income tax rates are higher for most investors than the rates on capital gains and dividends. Because tax-deferred accounts pay no tax on investment income or unrealized gains until the income is withdrawn, these are the ideal vehicles to hold taxable bonds, high turnover active equity managers, dividend-oriented investments, and REITs. REITs are rated low on the tax efficiency scale, as they are required by law to pay out at least 90% of their taxable income, and unlike other equities, this income is generally taxed at higher ordinary income tax rates.

What about commodities and MLPs?

Directly held commodity investments, such as ETFs designed to track the price of gold or silver, are categorized as “collectibles” and are taxed at a 28% long-term capital gains rate as opposed to the lower rates for equity investments. Even so, it may still make sense to hold these in a taxable account, as the gains when distributed from a tax-deferred account would be taxed at the investor’s marginal tax rate. Master Limited Partnerships (MLPs), despite their relatively high distribution levels, are often best held in a taxable account. Investors in MLPs receive a K-1 schedule which shows their portion of the MLP’s net income. Distributions are not taxed when they are received, unlike ordinary dividends which are taxed in the year they are realized. Instead, the distributions are considered a reduction in cost basis in the investment in the MLP. The tax liability from the distributions is only realized when the interest in the MLP is sold, and thus is deferred.

Constructing investment portfolios for clients should always be done with risk tolerance and liquidity needs as the primary driver. Broad asset allocation will likely be the determinant factor for reaching a client’s goals, but asset location, especially for high net worth clients, can be a key tool in maximizing after-tax return.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.

Natixis Investment Managers Solutions does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.

Exchange-Traded Funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund, and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF’s net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

Real estate investing may be subject to risks including but not limited to declines in the value of real estate, risks related to general economic conditions, changes in the value of the underlying property owned by the trust, and defaults by borrowers.

Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.

Master Limited Partnerships (MLPs) may trade less frequently than traditional investments such as equities, which may result in erratic price movement or difficulty in buying or selling. MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment, including the risk that an MLP could lose its tax status as a partnership.

Diversification does not guarantee a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Asset allocation does not ensure a profit or protect against loss.