Asset allocation has long been the mantra of financial advisers and smart investors intent on minimizing risk through diversification. Now, with the specter of higher taxes on income, qualified dividends, and long-term capital gains looming in 2011 and beyond, the idea of "asset location" for tax purposes is likely to become equally pervasive.
"Location" in this sense means where an asset finds its most suitable home: a taxable account, or a tax-deferred portfolio such as a 401(k) plan or individual retirement account (IRA).
This year, investors need to get ready for expiration of the Bush Administration's tax cuts and position their portfolios accordingly, says John Nersesian, head of Chicago-based Nuveen Investments' wealth management team, which works with financial advisers. At the margin, the top 35% income bracket will likely climb to 36% and 39.6%, while qualified dividends and long-term capital gains—on securities held for more than one year—will go from 15% to 20%. Even at the higher rates, assets generating dividends and long-term capital gains will still be very attractive compared with ordinary income tax rates of 36% and 39.6%, he says.
Tax planning for the next two years is going to be counterintuitive, experts warn. The conventional wisdom is to accelerate deductions such as on property taxes and charitable contributions and to defer income as long as possible, but the likelihood of higher tax rates in the future makes the opposite approach more beneficial for now, says Nersesian.
"I might consider accelerating my income to receive it now in a lower tax environment and deferring my deductions into the future when there's a higher tax bill to offset," he says.
Looking for Tax Gains
Harvesting tax gains for 2009 and 2010 before the long-term capital-gains rates go up is especially beneficial for people with low income due to either early retirement or being unemployed, Peter J. Canniff, a financial planner at Advanced Portfolio Design in Nashua, N.H., said in an e-mail message. That's because those in the lower income tax brackets, 15% and below, pay zero tax on their long-term capital gains in 2010. After this year, they will have to pay a 10% capital-gains tax and 20% if they are in tax brackets above 15%.
"The real trick is to get an idea how much you can get in capital gains without pushing your total taxable income up into the higher tax brackets, which would cause your capital gains to get taxed at the higher cap gains rate," he writes.
So which assets belong in which portfolios? Anything that's tax-advantaged should go into a taxable account. That includes municipal bonds and muni bond funds, which are tax-exempt. Stocks that pay high dividends such as utilities are eligible for the preferential 15% dividend tax only if they are held in a taxable portfolio. Finally, low-turnover assets like indexed mutual funds or a blue chip stock you plan to keep for many years belong in a taxable account because that's where you get the benefit of long-term capital-gains treatment. Exchange-traded funds (ETFs) are also a staple of these accounts because their in-kind creation and redemption process keeps capital gains to a minimum even when there's a lot of turnover in investors.
International stocks and bonds, and mutual funds that own them, should be put into a taxable portfolio since the interest and dividends paid on them aren't passed along entirely to a U.S. owner or U.S. fund, investment adviser John Smartt at Financial Counseling & Administration in Knoxville, Tenn., wrote in an e-mail message. "If these securities are owned in a regular currently taxed account, then the taxes paid are reclaimed as a direct, dollar for dollar tax credit against U.S. federal income taxes," he said. "But if owned in a tax-deferred account, there is no reclaiming of any benefit for these taxes paid."
Once an investor has retired, he can take the distribution on any assets within a taxable account without having to pay any further taxes.
Tax-deferred accounts such as IRAs and 401(k) plans should be reserved for less tax-efficient assets such as actively managed mutual funds with higher turnover and more frequent capital-gains distributions, including most small-cap funds, says Brent Burns, president of Asset Dedication, a Mill Valley (Calif.) firm that provides fixed-income asset allocation strategies to independent financial advisers. Short-term capital-gains distributions currently are taxed as ordinary income, up to 35% depending on your tax bracket, and likely up to 39.6% in the future.
IRAs and 401(k)s are also best used by investors who aggressively buy and sell securities, making them subject to short-term capital gains. Securities that produce taxable income, such as preferred stocks, real estate investment trusts (REITs), and corporate bonds, can get the maximum benefit from income compounding over time by being in tax-deferred accounts, says Nersesian at Nuveen. Any gains from an asset within a tax-deferred account will be taxed as ordinary income upon withdrawal.
Until now, investors' attention has been focused on wealth accumulation for retirement. But now the baby boomers are starting to confront the issue of how to withdraw this money intelligently, experts say. Burns at Asset Dedication advises people preparing for retirement to figure out how much of their Social Security income will be subject to income tax, so they know how much more they can withdraw each year from a tax-deferred account and remain in their desired tax bracket. Anything they need beyond that has to come out of their taxable accounts. A married couple, for example, will be taxed at the 15% rate as long as their income doesn't exceed $67,900. If they need $90,000 a year to support a certain lifestyle, they know they'll have to take $22,100 out of their taxable account, Burns says.
Retirees are better off deferring withdrawal of assets from retirement accounts and using other resources, if they have them, to meet their lifestyle needs, says Nersesian. The one exception is the opportunity to convert tax-deferred accounts into Roth IRAs, on which they pay the taxes up front. "I'm not suggesting most investors should convert, but at least they should look into the benefits of conversion," he says.
Most experts recommend Roth conversions this year where it makes sense for an investor, especially since the ban on conversions for people earning more than $100,000 a year was removed as of Jan. 1, 2010.
Roth Conversion Factors
Nersesian cites some factors to bear in mind when deciding whether to convert a conventional IRA to a Roth plan. Most important, Roth distributions on income earned on principal are only tax-free if you meet a five-year holding period requirement. Next, a conversion is only beneficial if you are able to pay the conversion taxes with outside monies instead of reducing the amount in your account to do so. Third, if you want to avoid the required minimum distribution that takes effect at age 70.5, Roth plans allow you to do so. Fourth, if you have nondeductible, or after-tax, contributions in your retirement account, those become tax-free after you convert those balances to a Roth account.
Be careful, though, if you have multiple retirement accounts, some of which have nondeductible contributions and some of which don't, because you're required to aggregate all those accounts on conversion and would only get credit for nondeductible contributions on a percentage basis.
A partial conversion is another option, says Nersesian. If you have a $100,000 IRA, you can choose to convert only a certain portion that keeps you at a particular tax bracket before you get bumped to a higher bracket. Partial conversions also provide a hedge: If you're still working past retirement age, keeping half your money in a regular IRA and half in a Roth account gives you some flexibility to make withdrawals during retirement from whichever account is most advantageous, he says.