How Asset Location Impacts Your Investment Tax Strategy

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Let’s imagine you’re in the market to purchase some kind of asset with the intent of growing your savings. What are your options? Stocks, bonds, ETFs, and mutual funds, to name a few. Picking the right investment for your financial goals can be tough, but there’s another important factor that many people forget to consider: the long-term tax implications of not just their investments but also the type of account they use to buy them.

Asset classes and investment accounts are subject to varying tax treatments. By thoughtfully considering the tax implications of both your assets and accounts, you might achieve a higher level of overall tax efficiency. This could potentially allow you to retain more of your investment funds, thereby contributing to the strength and resilience of your portfolio. 

How Your Investments Are Taxed

When we think of the tax status of an investment, we default to imagining that that asset is within a standard brokerage account. Within that brokerage account, some investments are more tax-efficient than others. Assets that incur long-term capital gains are taxed less than an asset that generates ordinary income. The difference is quite striking:

2024 Income Tax Brackets

Tax Rate Single Married filing jointly Married filing separately Head of household
10% $0 to $11,600 $0 to $23,200 $0 to $11,600 $0 to $16,550
12% $11,601 to $47,150 $23,201 to $94,300 $11,601 to $47,150 $16,551 to $63,100
22% $47,151 to $100,525 $94,301 to $201,050 $47,151 to $100,525 $63,101 to $100,500
24% $100,526 to $191,950 $201,051 to $383,900 $100,526 to $191,950 $100,501 to $191,950
32% $191,951 to $243,725 $383,901 to $487,450 $191,951 to $243,725 $191,951 to $243,700
35% $243,726 to $609,350 $487,451 to $731,200 $243,726 to $365,600 $243,701 to $609,350
37% Over $609,350 Over $731,200 Over $365,600 Over $609,350

2024 Long-term Capital Gains Tax Brackets

Filing Status 0% Rate 15% Rate 20% Rate
Single Up to $47,025 $47,026 – $518,900 Over $518,900
Married filing jointly Up to $94,050 $94,051 – $583,750 Over $583,750
Married filing separately Up to $47,025 $47,026 – $291,850 Over $291,850
Head of household Up to $63,000 $63,001 – $551,350 Over $551,350

As we can see, tax rates on standard income are, as of 2024, significantly higher than capital gains tax rates. 

So, which investment incurs which kind of tax within a brokerage account?

2024 Investment Tax Statuses (Within Brokerage Account)

Asset Class Tax Treatment
Stocks (Capital Gains)
  • Short-Term: Ordinary Income Rates
  • Long-Term: 0%, 15%, or 20%
  • Qualified Dividends: Long-Term Capital Gains Rates
  • Ordinary Dividends: Ordinary Income Rates
Bonds Interest Income: Ordinary Income Rates
Municipal Bonds (Muni Bonds) Interest: Generally Exempt from Federal Tax
Mutual Funds
  • Short-Term Gains: Ordinary Income Rates
  • Long-Term Gains: Long-Term Capital Gains Rates
  • Dividend Distributions: Qualified/Ordinary Dividends
Exchange-Traded Funds (ETFs)
  • Capital Gains Distributions: Rare, Similar to Mutual Funds
  • Dividend Distributions: Qualified/Ordinary Dividends
  • Capital Gains When Sold:
    • Short-Term: Ordinary Income Rates
    • Long-Term: 0%, 15%, or 20%

Now we have a good understanding of the standard tax rates offered by a brokerage account and the taxes each kind of asset class would incur. So, let’s add another variable. There are more or less five tax-advantaged investment accounts: the ubiquitous 401(K), 403(b), 457(b), the IRA, their Roth variants, the Health Savings Account, and the 529 Savings Account. All seek to grow your savings with the power of investing while offering tax benefits. How do they stack up compared to a brokerage account?

2024 Investment Account Tax Statuses

Account Type Tax Treatment
Brokerage Account
  • No Tax Advantages
  • Taxation:
    • Interest Income: Ordinary Income Rates
    • Capital Gains:
      • Short-Term: Ordinary Income Rates
      • Long-Term: 0%, 15%, or 20%
    • Dividends: Qualified/Ordinary Dividends
401(k), 403(b), 457(b)
  • Traditional: Pre-tax Contributions, Ordinary Income Rates on Withdrawals
  • Roth: After-tax Contributions, Tax-Free Withdrawals
Traditional IRA
  • Pre-tax Contributions (If Eligible), Ordinary Income Rates on Withdrawals
  • Tax-Deferred Growth
  • After-tax Contributions, Tax-Free Withdrawals
  • Tax-Free Growth
Health Savings Account (HSA)
  • Pre-tax Contributions, Tax-Free Withdrawals for Medical Expenses
  • Tax-Free Growth
  • Non-Medical Withdrawals After 65: Ordinary Income Rates
529 Account
  • After-tax Contributions
  • Tax-Free Growth
  • Tax-Free Withdrawals for Qualified Education Expenses

Each investment you own will have a separate tax journey based on its asset location. Let’s look at the bond as an example.

The Tax Status of a Bond

Brokerage Account

Imagine you have a bond in a regular taxable brokerage account. There are no tax advantages to purchasing and holding that bond in this account. You don’t defer taxes, and you don’t benefit from tax-free growth. You pay income taxes, purchase the bond, and then pay income taxes on the interest you receive from it each year. This process may not be the most efficient, and the constant tax drag might hinder your portfolio’s performance.

Traditional Tax-Deferred Account

A more tax-efficient way to invest would be to purchase a bond within an IRA or 401(k). In this scenario, you get a deduction for your contribution to your investment account, but you will pay regular income taxes on the proceeds when you retire. Here, you benefit from the initial deduction, potentially giving you greater funds to invest, and you may experience less annual tax drag compared to a brokerage account.

Roth Account

What if you placed that bond in a Roth account? You’d pay taxes on your regular income, purchase your bonds, and then never pay taxes on any of the interest you receive, provided you follow Roth withdrawal rules. This transforms a tax-heavy investment into a potentially more tax-efficient one, possibly making it a better choice for long-term growth.

Of course, there’s one nuance to consider: you have a limit to how much you can contribute to a Roth account each year. Do you want to allocate a portion of your contribution limit to a generally lower-yielding bond in an account that offers tax-free growth and withdrawals? Perhaps dividend-yielding growth stocks, which can potentially offer higher returns, are a better option for the Roth? 

Interested in a Roth conversion? Schedule some time here

Health Savings Account (HSA)

Lastly, we come to the ultimate tax-efficient account. With an HSA, you can take a tax deduction for your contribution, your investments can grow tax-free, and you can withdraw your funds without paying any taxes on the growth as long as they are used for qualified medical expenses. It doesn’t matter if your investment is a bond, a stock, an ETF, or a mutual fund. It also doesn’t matter if you generate qualified or ordinary dividends, long-term or short-term capital gains, or interest. As long as you follow the rules, your investments can remain free of taxation. Unfortunately, the HSA doesn’t make sense for everyone, nor is everyone eligible. 

Putting the Pieces Together

Finally, we come to the most challenging part: purchasing the correct assets within the proper account. What should go where? Of course, it depends on your financial goals, future tax rates, investment horizon, and estate planning considerations – among others. With that being said, it might be beneficial to place investments with high tax liabilities in accounts that can reduce or defer those liabilities.

For example, placing a high-interest bond in a Traditional IRA could be a wise choice. In a taxable account, you’d owe income taxes every year on the interest generated. Instead, with a Traditional IRA, you defer the income taxes on the interest until retirement, when you may be in a lower tax bracket, thereby reducing your overall tax burden.

Conversely, placing a stock that generates capital gains in a Traditional IRA might not be as advantageous. You would owe income tax on the withdrawals, converting what would have been lower-taxed capital gains into higher-taxed ordinary income.

Similarly, placing a tax-free municipal bond in a Roth account may not make sense either. Since the bond’s interest is already tax-free, using the Roth account’s tax-free growth benefits on it is inefficient. Roth accounts are better utilized for high-growth investments that would otherwise incur significant taxes.

Other Nuances To Consider

Portfolio Rebalancing

You have all of these accounts, each with their own assets and financial goals. But that doesn’t mean they shouldn’t work separately from each other. A top down, holistic view of your finances can help you rebalance your separate accounts as one portfolio, not several smaller ones. But keep in mind that rebalancing within a brokerage account can incur a tax liability, so when possible, it may be advantageous to rebalance within tax-advantaged accounts – which a holistic bird’s eye view of your portfolio can help accomplish. 

Tax Loss Harvesting

If you are forced to rebalance within a brokerage account, you may have the possibility to reduce your tax liabilities via tax-loss harvesting. This involves selling investments that have decreased in value to offset capital gains from other investments. The losses can be used to reduce your taxable income, potentially reducing your tax liability. You may even be able to carry over unused losses to future tax years, providing ongoing tax benefits. 

Withdrawal Strategies

Tax diversification of our assets and accounts can help us create a retirement withdrawal strategy with taxes top of mind. You can withdraw just the right amount from each account to avoid bumping up a tax bracket or to stay below tax limits. In this phase, careful attention should be paid to your social security payments, required minimum distributions (RMDs), and other income sources to manage your taxable income effectively.

In Conclusion

The next time you’re purchasing an investment, stop and think about the tax status of not just that investment but the account itself. Does it align with your long-term financial goals and tax plan? If not, you may want to reconsider either the asset or the account. Of course, in some accounts you may not have much of an option – for example, your 401(K) plan offerings. Or perhaps you don’t qualify for an IRA or HSA and have to make do with the accounts available to you. Finally, maybe you’re not interested in tax deductions now and are more concerned about generating as much tax-free income as possible via the Roth or alternatives to investing, such as cash-value life insurance plans. It all depends. 

If you’re unsure of your asset location strategy or don’t know where to start, we’d be happy to review your financial situation and provide recommendations. Feel free to reach out by scheduling a time in the calendar below!

Please Note: The information contained in this article is general in nature and for educational purposes only. Cornerstone Financial Services Group does not provide tax advice and one should always consult with their tax professional regarding their specific situation.

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