Portfolio Investment Manager Raleigh, Chapel Hill, Cary, Durham, NC

Tax-Efficient Investing and the Importance of Asset “Location”

In Asset Allocation, Bonds, Investments, Tax by Chip Hymiller

When it comes to structuring a tax-efficient investment portfolio, we believe it is important to consider “asset location.”  That is—which types of investments should be held in which accounts?  Conventional wisdom would reason as follows:

  • Tax-efficient investments should be held primarily in personal brokerage accounts.  This could include municipal bond funds, tax-efficient index funds and even individual stocks.Portfolio Investment Manager Raleigh, Chapel Hill, Cary, Durham, NC
  • Tax-inefficient or “income generating” investments should be held in tax-favored accounts like IRAs and 401k plans.  This would include most fixed income investments (bonds, preferred stocks, TIPS), as well as certain types of stock investments including REITS, dividend payer stocks and some actively managed stock mutual funds.

Unfortunately, positioning income generating (mostly conservative) investments in IRAs and tax-efficient (growth-oriented) investments in personal brokerage accounts, may not always be a good idea.

This is especially the case for those investors who are in the accumulation phase of their investment life cycle.  You might recall that we consider accumulators as those investors who are at least 10 years away from retirement.

What is different about accumulators?

The primary factor that influences asset location decisions for accumulators is the fact that distributions (prior to the age of 59 1/2) from IRAs and 401k plans could be subject to income tax and a 10% penalty on the distribution.

As such, when forced to take a distribution from their accounts (as a result of an extended unemployment or major unexpected expense), the most tax-efficient distribution order would likely be as follows:

  1. Cash held in an emergency fund (no tax no penalty)
  2. Proceeds from a personal investment account (no penalty and little or no tax)
  3. Money held in IRAs and 401k plans (subject to taxes and early withdrawal penalty).

Investment Strategy for Accumulators

Given the fact that for most accumulators, their personal brokerage account is considered “on deck” money for distribution purposes, we generally suggest an investment strategy that is both tax-efficient and conservatively positioned.

By being more conservative in a personal brokerage account, the hope is that there is some protection from selling equity investments at an inopportune time (after a stock market decline) in order to pay for an unexpected expense.

Portfolio Customization is Critical

Determining an appropriate investment strategy is a process that should be customized to reflect both the risk tolerance (emotional ability to withstand risk) and the risk capacity (the financial ability to withstand risk) of each investor.

We believe that working with an investment advisor who has the experience and the ability to consider, and minimize, the detrimental impact of taxes is a critically important component when building an enduring portfolio.

Click here for more insight into Beacon Financial Strategies’ investment philosophy.