Investing—Taxes February 24, 2010, 9:35PM EST

Taxes: Finding the Right Fit

What types of assets should go in taxable accounts? Non-taxable? Financial experts tell Bloomberg BusinessWeek their top ideas for "asset location"

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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."