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:
Location asset is a cornerstone for success for one simple reason . Taxable accounts differ from the tax-deferred accounts { 401 ( k ) , IRA and similar retirement } . Taxable accounts, you income tax on any dividends and capital gains generated by paying your investments. This tax significantly reduces the amount of reinvestment and annual investment growth . On the other hand , retirement accounts defer taxes which returns to connect without penalty and at a significantly faster rate . Asset location refers to the optimal placement of securities between taxable and tax-deferred accounts. To reward long-term compounding and significantly higher yields good choices. Investors Bad choices , or more generally , no choice , leading to below average results .
The effects are striking. Investors lose up to 20 % of their after - mislocating returns by investing in the wrong type of account . That says a recent study by 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 types of assets, stocks and bonds, to determine suitability for investing in tax - deferred accounts. Their conclusion ? Investors should hold shares in taxable accounts and bonds in tax - deferred accounts , to the extent possible . Young investors are the most to gain by following such advice . Three of the most powerful elements of investing - dividends , deferred taxes , and compound interest - combine for a dazzling effect on retirement income .
Unfortunately , the typical investor never takes advantage of all three benefits . A recent Federal Reserve survey shows Americans their taxable and tax-deferred investment accounts with identical effects. People focus on individual accounts instead of their entire portfolio. They ignore the benefits of allocating investments among various accounts and wind up with multiple accounts all hold the same. To their detriment , nearly half of all investors hold bonds in taxable accounts and stocks in the tax - deferred accounts.
Why asset location work :
Tax efficiency is more important than ever . Two recent changes are driven asset location strategy . Last year, tax , employment growth and Tax Relief Reconciliation Act of 2003 , cut top tax rates on dividends from 35% to 15 % . Same dividends , however, would be at the normal rate ( to 35 % ) taxed when withdrawn from a retirement account . The new law on the taxation of capital gains from 20% to 15 % . Since most equity investments generate income from both dividends and capital gains , investors realize lower tax bills when holding shares or equity funds in a taxable account .
Similarly , fixed income ( eg bonds ) and property trusts generate a steady stream of money . These interest payments are subject to the same ordinary income tax rates of up to 35 % . A tax - deferred retirement account offers investors the best possible care for these effects and the resulting profits .
That investment goes where ?
Fortunately, your asset location strategy are relatively simple . Place heavy duty assets in tax -deferred accounts first . Anything left over can go in taxable accounts . The academic study , the professors concluded with three general rules to help in decision making. First , search taxable bonds , real estate investment trusts ( REITs ) and related funds in tax-deferred accounts. Second , locate stocks and stock mutual funds in taxable accounts - even if you are an active trader and generate significant short-term gains . Third , never buy until you fill with taxable bonds or REITs . Complete a tax-deferred accounts municipal bonds The combination of composing and defer taxes on the higher yields of corporate bonds . If this all sounds a bit overwhelming , just check the table below .
Table 1 : Asset Locations for high efficiency and minimal taxes .
TAXABLE INCOME
- Inventories
- Tax - free or tax-deferred bonds ( munis , treasuries and savings bonds )
- Mutual funds invest in stocks or tax-advantaged bonds
Tax - deferred accounts ( traditional IRAs , 401 ( k ) s , and deferred annuities )
- Taxable bonds ( corporates , zeros , TIPS and high yields )
- REITs (Real Estate Investment Trusts)
- Mutual funds invest in bonds or taxable REIT
Two exceptions are worth noting . First , qualified distributions from Roth IRAs are tax free. In general , place assets with the greatest potential for returns within a Roth . Second, if a 401 ( k ) or IRA keeps all ( or nearly all) of your investment money , throw this article away and focus only on asset allocation .
Summary :
You , as an informed investor can take your return on investment . Control of taxes and related charges Reduce risks and increase returns Assign your investments . Find your investments to minimize . By managing all your accounts on the tax obstacle for your financial return
Tim Olson
TheAssetAdvisor.com
Mr. Olson is the editor of The Asset Advisor, a financial investment services proven strategies for no - load mutual fund investors . He brings 26 years of training and experience of the Stanford University , Ernst & Young financial advice , personal wealth management , and venture capital investing .
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