[For today’s post, I recommend reviewing my prior posts on the Ultimate Savings Hierarchy, Turndown for What?, (the) ABCs of Investment Accounts, What is a Fund?, The Hidden Cost When Investing, and Not Your Grandmas Guide to Stocks & Bonds. Those using target retirement fund investments will likely not benefit from this post. If you haven’t, please read the website disclosure statement.]
Welcome back and for today’s post, I will dig further into tax-efficient investing by focusing on asset allocation strategies. While this topic may sound complex, it is essential to understand. Simply put, asset allocation strategies keep more of your hard-earned money in your wallet. How, you ask? By paying taxes strategically.
I believe that every person should pay the taxes required of them, nothing more. However, for this belief to work, one must optimize their approach to investing! So, through today’s post, I will help demystify asset allocation strategies so that you can achieve a more optimal financial plan by aligning your investments and accounts.
Tax Efficient Investing Through Asset Allocation
Before we get started, some definitions are in order:
Strategic Location Investing (SLI): Placing investments into corresponding accounts that provide the most tax preferential treatment based on the tax characteristics of both.
We can think of SLI as using the tax code for your benefit! Now the tax code is undoubtedly an arduous piece of text, but in it, secrets can be found and utilized to your advantage. For today, we will be focusing on the treatment of assets that generate capital gains and ordinary income taxes, plus how to allocate these assets amongst different types of retirement accounts. Now gains are just a fancy word for income, which can come in the following flavors:
Ordinary Income (OI): Income earned from a job or investments that generate interest payments or short-term capital gains.
Interest Payments: Payments of profit made from a borrower to a lender for the privilege of borrowing money.
Capital Gains (CG): Gains earned from the sale of (investment) assets.
Short-term Capital Gains (STCG): Income generated by selling (investment) assets that have been held for less than one year.
Long-term Capital Gains (LTCG): Income made by selling (investment) assets that have been held for one year or greater. Additionally, stock dividend payments are LTCG.
2023 Tax Rate Tables
Now that we know our terminology, I will outline the different tax rates for the 2023 tax year. Please reference the tax tables for your situation and keep in mind that these rates and amounts change frequently. For the most accurate rates and dollar amounts, please visit IRS.gov.
Ordinary Income Tables
|Taxable Income||Tax Rate|
|$0 to $11,000||10%|
|$11,000 – $44,725||$1,100 + 12% of the amount over $11,000|
|$44,726 – $95,375||$5,147 + 22% of the amount over $44,725|
|$95,376 – $182,100||$16,2901 + 24% of the amount over $95,375|
|$182,101 – $231,250||$37,104 + 32% of the amount over $182,100|
|$209,426 – $578,125||$52,832 + 35% of the amount over $231,250|
|$578,126 or more||$174,238.25 + 37% of the amount over $578,125|
Married (Filing Together)
|Taxable Income||Tax Rate|
|$0 – $22,000||10%|
|$22,000 – $89,450||$2,200 + 12% of the amount over $22,000|
|$89,451 – $190,750||$10,294 + 22% of the amount over $89,450|
|$190,751 – $364,200||$32,580 + 24% of the amount over $190,751|
|$364,201 – $462,500||$74,208 + 32% of the amount over $364,200|
|$462,501 – $693,750||$105,664 + 35% of the amount over $462,500|
|$693,751 or more||$186,601.5 + 37% of the amount over $693,750|
Head of Household
|Taxable Income||Tax Rate|
|$0 – $15,700||10%|
|$15,701 – $59,850||$1,570 + 12% of the amount over $15,700|
|$59,851 – $95,350||$6,868 + 22% of the amount over $59,850|
|$95,351 – $182,100||$14,678 + 24% of the amount over $95,350|
|$182,101 – $231,250||$35,498 + 32% of the amount over $182,100|
|$231,251 – $578,100||$51,226 + 35% of the amount over $231,250|
|$578,101 or more||$172,623.5 + 37% of the amount over $578,100|
Long-term Capital Gains Income Tables
|Long-term Gains||Tax Rate|
|$0 – $44,625||0%|
|$44,626 – $492,300||15%|
|$492,301 or more||20%|
Married (Filing Together)
|Long-term Gains||Tax Rate|
|$0 – $89,250||0%|
|$89,251 – $553,850||15%|
|$553,851 or more||20%|
Head of Household
|Long-term Gains||Tax Rate|
|$0 – $59,750||0%|
|$59,751 – $523,050||15%|
|$523,051 or more||20%|
Sleepy yet? I promise the boring part is over! As you may have noticed above, the government actively incentives people, from a tax standpoint, to earn income on their capital/investments, compared to laboring.
Notably, long-term capital gain rates have triggered significant public debate in America as of late on how the wealthy use them to their advantage. I hope that through using this article, ordinary Americans can capitalize on this preferential treatment, too, by using the SLI approach.
Now, my strategy envisions an ideal situation, which, admit-ably, will rarely happen. Instead, you will have spillover of assets that could go into many categories or not have enough income or assets to entirely take advantage of this approach. Regardless, use this post as a reference, and please, focus on saving above all else.
For a refresher on saving properly, use my Ultimate Savings Hierarchy (USH) guide. Once you are familiar with the USH approach, SLI a great way to ensure, you keep more of your hard-earned cash. Importantly, this strategy assumes that tax treatment of your assets is of utmost importance and that paying the lowest possible rate is your goal.
So, without further ado, I present the SLI flow chart:
SLI Reference Guide
|Stocks (& Funds)||Depends||Yes||Yes||Yes|
|Gov & Corp Bonds (& Funds)||Yes||No||No||No|
|High Turnover Funds||Yes||Yes||Yes||No|
|Low Turnover Funds||Depends||Depends||Depends||Yes|
Assets: Stocks, Bonds, Options, Cryptocurrencies, Precious Metals, & REITs
Accounts: Tax-deferred, Roth, HSA, and after-tax brokerage
For those who prefer an explanation of why these investments should be held in the selected accounts, continue reading!
What to hold in your traditional IRA & 401(k) accounts
Likely the most prolific retirement account, the traditional 401(k) & IRA accounts allow savers to put money in before taxes, where it then grows tax-deferred until taken out. However, because this money has never been taxed, it is all taxed as ordinary income when withdrawn. Thus, in an ideal world, you should hold assets that will be taxed as ordinary income when you receive payments from or sell the assets.
Why is this? Because if you were to receive a lower tax rate on investments by holding them outside a traditional account, you would be penalizing yourself by placing them in the traditional account type. Thus, we ensure tax efficiency by matching our ordinary tax rate investments to traditional accounts and lower tax rate investments to our after-tax or tax-free accounts.
So what assets are ideally held in traditional accounts? Government & Corporate Bonds, Investments Subject to STCG, Precious Metals, and High Turnover Funds.
Government & Corporate Bonds
Bonds, whether issued by governments or corporations, pay interest to the owner. These interest payments generally occur twice a year and are always considered ordinary income and taxed accordingly. As a result, holding bonds in a traditional account matches our tax types! The exception to this rule occurs if the bond is a municipal one, known as a muni; munis are generally tax-exempt and thus should never be held in a traditional account, ever!
Investments Subject to STCG
Do you regularly trade options, cryptocurrencies, or stocks? If so, these assets will be taxed as ordinary income if held for less than one year under the STCG rate. Notably, options almost always incur STCG when an investor makes money from them.
In addition to these three investments, funds that have high turnover rates will regularly incur STCG. Thus, consider placing high turnover funds in traditional accounts if possible.
The third category of investments you should ideally hold in traditional accounts includes precious metals like gold and silver. Under the tax code, gains on precious metals are taxed at the collectibles tax rate (similar to art). Unfortunately for most people, collectibles have a flat tax of 28%, ouch! So, if you are an investor who wants exposure to these tangible assets, consider ETFs, which allow you to easily own them in traditional accounts and incur meager costs/fees to buy, sell, and hold them.
If you are physically holding gold for an apocalyptic scenario, I will encourage you to reconsider. For example, what are the chances someone will trade food for a piece of metal when no government exists?
Gold should be used as an inflation hedge and portfolio diversifier, nothing else.
Now, as a final catch-all category, any investments that you want to avoid paying taxes on now should be held in a traditional account. This goes against the ethos of capitalizing on SLI, but this will make sense for some people for various reasons.
Wait a minute
But Olaf, couldn’t you hold many of these investments above in Roth, HSA, and after-tax accounts as well? Absolutely and we will cover that in a moment! However, before moving onto the other account types, it is essential to note that REITs should not be held in traditional accounts, if possible, just like munis.
What to hold in your Roth IRA, Roth 401(k), & HSA accounts
As a quick refresher, with Roth, you pay taxes now, and all future growth is tax-free. With the HSA, you put money in before taxes, and when withdrawn, if for medical expenses, you never pay taxes on it; this applies to the growth of your money as well, so long as you do not live in CA or NJ.
So, what types of investments are best suited for these tax-free Roth & HSA accounts? REITs, Investments Subject to STCG, Precious Metals, High Turnover Funds, and High Growth Potential Investments.
REITS, also known as Real Estate Investment Trusts, are a particular type of company that (generally) invests in real estate. Just like ordinary companies, REITs issue stocks that represent ownership in the REIT.
The difference between REIT stocks and regular stocks is that REITs pay zero corporate income taxes. Now, most corporations pay income taxes, issue dividends, and then the investor pays LTCG on the dividends. With REITs, instead of paying taxes on the corporate level, they issue distributions to shareholders, who then pay all taxes due in four different ways:
•Ordinary income distribution: This is a dividend of shared profits from the company. Because this profit was not taxed on a corporate level, shareholders pay ordinary income taxes on it; however, the first 20% are not taxed due to the Tax Cuts & Jobs Act, which treats these as passthrough income.
•Return of capital distribution: This is when the REIT returns part of your initial investment to you. The government assumes you had already paid taxes on this component when you invested it, so it is not taxable when returned. This is a huge reason not to hold REITs in a traditional account. Why pay taxes on something that you otherwise would not have to if held in another account!
•Capital Gains Distribution: These can include STCG and or LTCG distributions. This type of distribution occurs when a REIT sells a property it owns! If the property was owned for less than a year, it is treated as a STCG distribution; if held for a year or greater, it is a LTCG distribution. Because LTCG distributions are frequent amongst REITs, why pay the higher (traditional) income tax rate? Pay nothing instead!
LTCG, STCG, & Collectible Investments
•For frequent traders of traditional or cryptocurrency investments, the Roth & HSA accounts make sense. Why? Because frequent traders, whether of classic or cryptocurrency investments, are placing trades that more regularly incur STCG tax rates. This likelihood stems from the fact that frequent traders are unlikely to hold their investments for at least one year.
•Option trades are generally treated as STCG and as a result, placing them in tax-free accounts helps save you money! The caveat is that some option trades are restricted from this account type.
•Now, the sister of STCG is LTCG. With investments that generate LTCG, they are best suited for after-tax or no-tax accounts. The reasoning for placing LTCG investments in these accounts is that putting them in traditional accounts would only cause you to pay more in taxes than you otherwise.
•For collectible investments, such as precious metal ETFs, they feel at home in Roth & HSA accounts since they generally have a much higher tax rate than stock investments.
High Growth Potential
The final category for tax-free accounts includes investments with high growth potential. Consider this: If you place high growth potential investments in your HSA and Roth accounts and slow growth ones in traditional accounts, you can minimize how much you will pay in future taxes! This is because your growth occurred in tax-free accounts and your safer investments, like bonds, grew modestly in accounts that have yet to be taxed.
What to hold in your ordinary, after-tax brokerage account
We have made it to our final account type, commonly known as the after-tax brokerage account. This non-tax preferential account has several tricks up its sleeves, making it an excellent account to save and invest within. For example, there is no such thing as an early withdrawal penalty in brokerage accounts, and long-term gains are taxed at (generally) lower rates.
As a result, after-tax brokerage accounts are widely used by countless investors. So, I am sure you are wondering, what assets make the most sense to hold in these accounts? Well, they include: Low Turnover Rate Funds, Stocks & Stock Funds, REITs, and Munis.
Low Turnover, Stocks & Stock Funds
As previously covered, any eligible LTCG investments should be held in after-tax brokerage or no-tax account types. Thus, stock and stock funds, which will be held for periods of one year or greater, make perfect sense in brokerage accounts. Notably, low turnover rate funds are the type that should be in after-tax accounts since they generate fewer STCG distributions than their active brethren.
When it comes to REITs, we learned that they could return non-taxable, STCG, LTCG, and passthrough income due to their unique tax treatment. Meaningfully, the treatment of REIT dividends as passthrough income allows for the first 20% of dividend payments to be tax-free when held in an after-tax account! Additionally, their participation in returns of non-taxable and LTCG income solidifies their placement in after-tax accounts
Lastly, Municipal Bonds generally have tax-exempt treatment on the local, state, and federal levels. You essentially get Roth treatment by placing munis in after-tax brokerage accounts, with no strings attached! Thus, after-tax accounts are the ideal and preferred place to hold munis. However, government and corporate bonds will always be treated as taxable income, so they should be avoided in after-tax accounts.
Whoa! That was quite the dissertation on asset tax treatment and account types. As learned above, each asset class has a unique tax treatment, which can be harnessed to optimize your tax situation. While this is only a guide, not a set-in-stone requirement for everyone, I hope that you have found the SLI approach to be valuable.
What do you think? Do you already invest this way, or do you prefer investing in different ways using the multitude of account types available? Let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time