In this article, I'm going to discuss location optimization. Location optimization, once you understand it, can be a great tool to save your clients tax dollars while differentiating yourself from the competition.
Location optimization, in basic terms, is locating specific types of investments in specific types of accounts to minimize taxes. Let's look at the three elements in the definition: Specific types of investments, specific types of accounts, to minimize taxes.
Location optimization cannot apply if the investor doesn't hold different types of investments. For example, a client's child has a taxable account and a Roth IRA, both holding an asset allocation fund. Since she only holds an asset allocation fund, there are not different types of investments and there is no opportunity for location optimization.
Likewise, location optimization cannot apply if the investor doesn't have different types of accounts. For example, you have a client with a rollover IRA of $2 million and no other accounts. Although the IRA holds many different types of investments, such as equities, bonds and commodities, since he only has one type of account, there is no opportunity for "mixing and matching" tax treatments.
So, let's say you have a client with multiple investment types in multiple accounts. To apply location optimization, you and the client must want to reduce taxes. You think this is a no-brainer, right? Well, it should be, but it's not. The reason? With location optimization, the client's individual accounts will not each hold the same investments. Therefore, each account will perform differently than the others. Will your client be ok with her IRA showing a lower performance number than her taxable account? Are you willing to train your clients to only look at returns at a portfolio level and not at the individual account level? And, finally, are you willing to do the work (and invest in the software necessary) to implement location optimization? Saving taxes needs to be more important than these obstacles if you want to apply location optimization.
Let’s get to the nitty gritty. There are essentially three types of accounts: taxable, tax-deferred and non-taxable. Taxable accounts are straightforward. Income is taxed as realized. Taxable bond interest, nonqualified dividends and short-term capital gains are all taxed at ordinary rates. Long-term capital gains are taxed at capital gain rates only when sold.
Non taxable accounts are pretty straightforward also. There's never any tax applied to the principal, income or growth in these accounts. The obvious example of this is the Roth IRA.
Tax-deferred accounts includes a whole lot of accounts such as retirement accounts, life insurance accounts, and annuities. Tax-deferred accounts do not incur tax on growth or income accumulated within the account. However, when funds are withdrawn, income will be reported at ordinary rates. The tax burden will also carry over to heirs of an inherited tax deferred account.
To summarize, taxable accounts pay tax right away on current income but can defer tax on appreciation, eventually paying capital gains rates when sold (or no tax if held until death). Nontaxable accounts never pay tax. And tax-deferred accounts are subject to ordinary tax only when distributions are made - or when inherited.
Now, let's look at the different types of investments - according to tax characteristics. Some investments throw off ongoing ordinary income, like taxable bonds. Other investments are held primarily for appreciation. Still other investments are held for long term growth.
Matching the investment types to the most appropriate types of accounts can save your clients a lot of taxes! In general, you will want to hold tax inefficient investments like bonds in tax-deferred accounts. The interest will not incur current taxes, ordinary tax will only be paid on distribution. That's ok because it would have been subject to ordinary tax anyway.
You'll want to put appreciating investments, like US stock funds, in taxable accounts. You don't pay tax on appreciation until sold, at which point, gains will be taxed at capital gain rates. Appreciating investments held in an IRA, will be taxed at ordinary rates. It's like telling Uncle Sam you're ok with paying twice as much tax!
Finally, high growth investments should be held in the Roth to get the biggest bang for the buck on the forever no-tax treatment. It's true that these investments can be volatile. However, since Roth IRAs are typically the last account to be tapped for distributions, they can ride out the short term ups and downs.
Implementing location optimization can be difficult without automation. A word from our sponsors: ByAllAccounts allows you to manage your clients’ 401k’s and other outside accounts along with the rest of their portfolios. Total Rebalance Expert allows you to say where you'd like certain investments held. You can even set priorities. For example, you want the IRA to hold TIPS, but if there is still room in the IRA, you want to fill the rest of the bucket with corporate bonds. Finally, TRX can quantify savings from this strategy so you can inform your clients.
Do you want to save your clients tax dollars and do you want to differentiate yourself from the competition? Then it's time to implement location optimization! With automation, location optimization is easy.
Sheryl Rowling, CPA/PFS is chief executive of Total Rebalance Expert and principal at Rowling & Associates. She is also a columnist for both Investment News and Advisors4Advisors.
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