Fees can be a blind spot in your investment portfolio

Inattention to taxes can cost investors big money.

Many investors are probably familiar with the concept of asset allocation, which involves selecting the right mix of stocks and bonds (say, 60/40) to balance investment risk and return.

But where those assets are held — meaning the types of accounts in which stocks and bonds are held — is probably just as important, especially for wealthier investors, according to financial advisers.

This “asset placement” strategy aims to minimize taxes, thereby increasing investors’ after-tax returns.

“Wealthier people should be as focused on tax allocation as they are on asset allocation,” said Ted Jenkin, an Atlanta-based certified financial planner and member of CNBC’s Advisory Board. “And I’m not.”

Asset location “really starts to make sense” once investors’ income is high enough to place them in the 24 percent federal marginal income tax bracket, said Jenkin, founder of oXYGen Financial.

In 2024, the 24% bracket starts at about $100,000 of taxable income for singles and about $201,000 for married couples filing a joint tax return.

Asset location uses two basic principles, according to Connor McGuire, CFP at Vanguard Personal Advisor.

First, not all investment accounts are taxed the same way.

There are three main types of accounts:

• Deferred tax. These include traditional individual retirement accounts (eg, pre-tax) and 401(k) plans. Investors defer tax on contributions but pay later on withdrawals.
• Tax free. These include Roth IRAs and 401(k) plans. Investors pay the tax up front, but not later after the withdrawal.
• Taxable. These include traditional brokerage accounts. Investors pay tax when they earn dividends or interest or on sale if there is a profit.

Additionally, investment income is taxed differently depending on the type of asset, McGuire said.

For example, interest income is taxed at an investor’s ordinary income tax rates. Top earners could pay 37% or more for such interest.

But gains on investments like stocks held for more than a year are generally taxed at a lower federal rate. Those long-term capital gains tax rates are 15 percent for many investors and 20 percent for top earners (plus any surcharges), McGuire said.

At a high level, asset location involves holding high-tax or tax-inefficient investments in tax-preferred retirement accounts such as 401(k) plans and IRAs.

Instead, investors would generally place investments with more favorable tax rates and efficiencies in taxable accounts.

“It’s important because you want to reduce tax frequency,” said Robert Keebler, a Green Bay, Wis.-based certified public accountant and partner at Keebler & Associates.

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Using such a strategy can increase after-tax returns by 0.05% to 0.3% per year, depending on the investor, according to a 2022 Vanguard analysis.

According to these calculations, an investor with a $1 million portfolio split equally between stocks and bonds and spread across all three types of accounts (traditional, Roth, and taxable) could save $74,000 after 30 years by using asset location, McGuire said.

Investors should use the asset location within an appropriate asset allocation, such as a 60/40 mix of stocks and bonds, advisers explain.

Many bonds and bond funds are generally better suited to tax-deferred or tax-exempt accounts, they said.

“Earnings on bond investments are mostly interest and taxed at ordinary income tax rates, which means up to 37% growth plus any surcharges for high-income investors,” McGuire said. “So you want those bonds sheltered.”

Certain stock investments, such as stock funds that are “super-actively managed” and generate ample short-term capital gains, generally belong in tax-preferred accounts, Keebler said.

(Short-term capital gains are taxed on investments held for a year or less. They are taxed as ordinary income instead of at long-term preferential rates.)

High-growth investments likely belong in a Roth account instead of a pre-tax retirement account because investors won’t pay taxes on gains later, Keebler said. (This assumes investors follow the appropriate Roth withdrawal rules.)

Individual stocks that investors buy and hold for long-term growth, and stock funds with less frequent internal trading (generally index funds instead of actively managed ones), are generally better suited for taxable accounts, have said the counselor.

Municipal bonds are also generally better suited in taxable accounts, advisers said. That’s because their interest is exempt from federal tax.

Investors should weigh the specifics of each account type. For example, it may be more difficult to access funds in a retirement account before age 59 1/2 than in a taxable account.

The benefits of diversifying into different types of accounts go beyond investing.

For example, withdrawals from pre-tax 401(k) plans and IRAs are generally considered taxable income and therefore could trigger higher Medicare Part B and Part D premiums. Conversely, withdrawing from a Roth account could help prevent these higher premiums because retirement distributions generally don’t count as taxable income.

Plus, it’s impossible to know what tax rates and account taxation will be like decades from now, Jenkin said.

Having money in various accounts will provide tax flexibility in the future, he added.