Any suggestions and illustrations in this blog are not intended as financial advice. They are my personal opinions.
Asset location concerns the best tax-beneficial places to have your investments. This is not an investment strategy but a tax strategy that determines what type of account the investments should be held in.
Some Basic Rules
- Keep in mind that there are many exceptions, and I am providing the general rules.
- Anything with taxes is subject to change precipitously, so always check with your tax adviser before you do anything.
- In some cases, it might be advantageous to also check with your investment advisor or financial planner.
Individual Accounts
- Any income in an individual account will be taxed in some manner.
- The receipt of interest will be taxed at ordinary income rates.
- The receipt of dividends will be taxed at capital gains rates.
- The realization of gains on securities held for more than one year will be taxed at capital gains rates.
- There are special capital gains rates for sales of real estate, collectibles, Section 1256 contracts and other situations. This is now getting technical and could be confusing, so I will be limiting this discussion to stocks and corporate bonds. For anything else, and also for this, check with your tax advisor before doing anything.
Tax-Deferred Accounts
- Any investment income in a tax-deferred account, such as an IRA or 401 (k), will not be taxed until distributions are made from that account.
- Almost all distributions will be taxed at ordinary income rates, regardless of the nature of the income in the tax-deferred account.
- The distributions of money you contributed to that account will also be taxed at ordinary income rates, since it was previously deducted on your tax return.
- There is an exception for distributions of non-deductible contributions that you made to the account. However, how they escape tax is convoluted, and that should be checked with your advisor.
- These rules also apply to distributions from fixed and variable annuities and certain distributions from immediate annuities, but I will not cover these further.
- These rules do not apply to Roth IRA accounts.
Here Is Where the Location Matters
- Because distributions from an IRA (I will use “IRA” for the rest of this blog to refer to all types of tax-deferred accounts) are fully taxed, that means that:
- All dividends from stocks and capital gains that are distributed will be taxed as ordinary income, i.e., the tax benefits for these investments will be lost.
- Rather, it would be preferred for these investments to be made in individual accounts.
- Because interest is fully taxed when received, it would be better for these investments to be in an IRA instead of stocks.
- This might not matter much if the interest is pretty much distributed as received.
- However, if the interest is accumulated and reinvested, then it would be more advantageous to have these investments in an IRA since there would be no taxation when the interest is received, and they would be left to make further investments that would be compounded.
- All transactions within an IRA are tax-deferred when they occur.
Choices
- Some people may not have choices (based on many factors) of the location, so there is no opportunity to decide on this.
- However, where there is a choice, the better location would be:
Put Interest-Bearing Investments in an IRA.
Put Stocks in Your Individual Name.
What to Do Now
- To the extent you have equal amounts of stocks in an IRA and bonds in your individual name, you could sell the stocks and use the proceeds to buy the same bonds in your IRA.
- Note that there would be no taxation on your gains since the IRA is not taxed on gains, and you are only taxed when you receive a distribution.
- Simultaneously, you could sell the bonds and buy the same stocks in your individual name that you just sold in your IRA.
- Buying the same stocks or stock mutual funds might raise some tax issues if you had losses on some positions. To avoid this, you could buy back similar securities so your portfolio would maintain the same stock market exposure.
- When you sell the bonds before maturity, there might be some losses, so check with your tax, investment or financial advisor. However, if you buy back similar bonds, your investment position would remain the same.
- Note that if you have bond funds, the losses might be significant.
- This is a plan that does not need to be executed all at once but could be done in stages until fully implemented.
- The timing would be based on your circumstances, the individual investments you have and the tax basis.
Added Tax Benefits of Stocks in an Individual’s Name
- Stocks owned individually when you die have their basis stepped up to the date of death value (or the value six months later under special circumstances), and any gains will fully escape capital gains taxation.
- This cannot occur in an IRA since the funds in an IRA, including any capital gains, will be fully taxed as ordinary income when distributed.
- Some stocks owned in your individual name that have appreciated significantly can be donated to a charity, and you will get the full tax deduction for the value of the stocks contributed without picking up the appreciation as a capital gain.
- Losses on stocks sold in your individual name can be used to offset capital gains, and excess losses up to $3,000 per year can be deducted against your other income.
- Losses on stocks sold in your individual name can be used to offset capital gains from the sale of collectibles, which might be taxed at a 28% tax rate. If this is a possibility for you, it can be a substantial loophole if handled properly.
- Stocks can be borrowed against if you need cash or want to buy on margin (which cannot be done in an IRA).
- Lower paying dividends compared to taxable interest will cause your adjusted gross income to be reduced, and this might result in lower Medicare premiums. So would the non-recognition of gains when you donate appreciated securities if your intention is to liquidate that portion of your portfolio.
Final Thoughts
This is complicated and might seem more complicated than it really is. However, I know far too many people who have their IRAs and 401 (k) s in stock funds while they own tax-free municipal bonds in their own name. Reconfiguring the stock ownership to their own name and buying higher-yielding corporate bonds in their IRA could result in significant tax savings and other benefits. My advice is to sit down with your financial advisor and work through it with them based on your situation.
I find that most everything new seems complicated until it is done for the first time, and then miraculously it doesn’t seem so complicated. Anyway, we are dealing with your ultimate financial security, and that should be worth spending some time to make sure you are doing the best you can.
Contact Me
If you have any tax, business, financial or leadership or management issues you want to discuss please do not hesitate to contact me.
