Asset Location ? Increase Investing Returns & Reduce Your Taxes

Location ? Once the holy grail only for real estate investors is fast becoming the mantra for every stock, bond, and mutual fund investor. Experts and studies now recognize managing asset location is second only to asset allocation in determining the success of your investment returns.

Importance of Asset Location:
Asset location is a cornerstone to success for a simple reason. Taxable accounts differ from tax-deferred accounts {401(k), IRA and similar retirement}. Taxable accounts require you to pay income tax on every dividend and capital gain generated by your investments. This tax substantially reduces the amount of reinvestment and annual investment growth. On the other hand, retirement accounts defer taxes allowing returns to compound without penalty and at a substantially faster rate. Asset location refers to the optimal placement of securities between taxable and tax-deferred accounts. Good choices reward investors with long-term compounding and significantly higher returns. Poor choices, or more commonly, no choice, leads to below average results.

The effects are striking. Investors lose up to 20% of their after-tax returns by mislocating investments in the wrong type of account. So says a recent study from three finance professors Robert Dammon and Chester S. Spatt, of Carnegie Mellon University, and Harold H. Zhang of the University of North Carolina. The professors analyzed two asset classes, stocks and bonds, to determine suitability for investing within tax-deferred accounts. Their conclusion? Investors should keep equities in taxable accounts and bonds in tax-deferred accounts, to the greatest extent possible. Young investors stand the most to gain by following such advice. Three of the most powerful elements of investing -- dividends, deferred taxes, and compounding interest ? combine for a staggering effect to retirement income.

Unfortunately, the typical investor never takes advantage of all three benefits. A recent Federal Reserve survey shows Americans invest their taxable and tax-deferred accounts with identical securities. People focus on individual accounts rather than their entire portfolio. They ignore the benefits of allocating investments among different accounts and wind up with several accounts all holding the exact same thing. To their detriment, nearly half of all investors own bonds in taxable accounts and stocks in tax-deferred accounts.

Why asset location works:
Tax efficiency is more important than ever. Two recent changes have driven asset location strategy. Last year's tax cut, the Jobs and Growth Tax Relief Reconciliation Act of 2003, slashed top tax rates on dividends from 35% to 15%. Those same dividends, however, would be taxed at the ordinary rate (up to 35%) when withdrawn from a retirement account. The new law further cut taxes on capital gains from 20% to 15%. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or equity mutual funds within a taxable account.

Similarly, fixed-income investments (e.g. bonds) and real estate trusts generate a regular flow of cash. These interest payments are subject to the same ordinary income tax rates of up to 35%. A tax-deferred retirement account provides investors with the best possible shelter for such securities and their resulting profits.

Which investment goes where?
Fortunately, your asset location strategy can be relatively simple. Place highly taxed assets in the tax-deferred accounts first. Anything left over can go into the taxable accounts. From the academic study, the professors concluded with three general rules to help with the decision process. First, locate taxable bonds, real estate investment trusts (REITs) and related mutual funds into tax-deferred accounts. Second, locate stocks and equity mutual funds into taxable accounts ? even if you are an active trader and generate substantial short-term gains. Third, never buy a municipal bond until you completely fill tax-deferred accounts with taxable bonds or REITs. The combination of compounding and deferring taxes on the higher yields of corporate bonds is. If all this sounds a little overwhelming, just consult the table below.

Table 1: Asset Locations for High Returns and Minimal Taxes.

TAXABLE ACCOUNTS
-- Stocks
-- Tax-free or tax-deferred bonds (munis, treasuries, and savings bonds)
-- Mutual funds investing in stocks or tax-advantaged bonds

TAX-DEFERRED ACCOUNTS (traditional IRAs, 401(k)s, and deferred annuities)
-- Taxable bonds (corporates, zeroes, TIPS, and high yields)
-- REITS (Real Estate Investment Trusts)
-- Mutual funds investing in taxable bonds or REITS

Two exceptions are worth noting. First, qualified distributions from Roth IRAs are tax free. Generally speaking, place assets with the greatest potential for returns inside a Roth. Second, if a 401(k) or IRA holds all (or nearly all) your investment money, throw this article away and focus only on asset allocation.

Summary:
You, as an informed investor, can take control over taxes and related expenses to your investment returns. Allocate your investments to reduce risk and increase returns. Locate your investments by managing all your accounts to minimize the tax drag on your financial returns.

Tim Olson

TheAssetAdvisor.com

Mr. Olson is the editor of The Asset Advisor, a financial investment service providing proven strategies for no-load mutual fund investors. He brings 26 years of education and experience from Stanford University, Ernst & Young financial consulting, personal wealth management, and venture capital investing.

Subscribe to our free newsletter

---

Global Markets: A Window on the World Economy

Expectations drive the market. Every stock price is driven by... Read More

Shareholders Meeting Changing With Times

A significant number of corporations that settled accounts in the... Read More

Numismatics are for Collectors, Not Investors

As a precious metals investor, you may heard much about... Read More

Stock Market Retirement Investment Plan

For a successful retirement investment plan to work in the... Read More

Success Trading: More Basic Terminology for New Traders

One important aspect of trading the markets is to understand... Read More

Stock Market Money Management Skills

Let's start by saying: You can't be afraid to take... Read More

Trading For A Living - Part 2

In part 1 of this article I started to look... Read More

Understanding The Real Rate of Return!

There is one indicator more than any other which determines... Read More

Investing: Do You Want To Make Money, Or Would You Rather Fool Around?

It always amazes me how much stock market investors resemble... Read More

Wit and Wisdom on Money, Wall Street and Success - Part #4

Can you concisely summarize your investment philosophy in a few... Read More

Reading Between The Lines In Annual Proxy Statements

Upper Saddle River, N.J. - May 11, 2005 - Now... Read More

A Gadfly On A Dinosaurs Butt, Or The Hood-winking Of The American Investor

Have you ever noticed how some words in the English... Read More

Press Release Scams and Successes: Reading Between the Lines

Press releases are a means through which companies can keep... Read More

Bad News - Why The Financial News Media Can Cost You Money!

The communication innovations we have around us today like the... Read More

How to Invest Your Money

Think carefully on how to invest your money because if... Read More

Scots Beat Yanks in China Bank Deal

With visions of an ATM in every neighborhood in China,... Read More

The Benefits of Laddering Your CD Investments

If you've decided to stock some money away in a... Read More

Success Trading: Yet More Basic Terminology for New Traders

In this day and age of online brokers for virtually... Read More

A Secret Revealed: Why Most (Day) Traders Fail

The following perspective on (day) trading comes from my many... Read More

The Perfect Mutual Fund

The Perfect Mutual Fund is the one you build yourself!The... Read More

Is Starting A Business For Me? What To Consider Before Starting A Business

Do you have the right temperament?Starting a small business is... Read More

Discipline in Trading and Investing

The one thing I can think of that most affects... Read More

Options Education: Financing the Calendar!

As a trader, one of the key things that I... Read More

Angels, Are They Real?

They're real, but few survive. High risk investing is dangerous... Read More

Gold and Silver Maple Leafs Get New Packaging

Gold Maple Leafs and Silver Maple Leafs are receiving packaging... Read More