Location, Location, Location

The idea for this article came to me after a recent visit to my barber. As my barber, Rob, snipped away at my ever-decreasing number of hairs, he told me two very interesting stories. The first story was about when he decided to open his own shop and his experience scouting for a location to hang his red, white, and blue barber�s pole. The second story was about his recent house hunting experience with his fianc�. When I asked him what he was looking for in a home his response was, �the same thing I looked for when I found this place [the barber shop]�a nice place in a good location.�

Anyone who has ever started his or her own business, looked for a house, or even set up a lemonade stand as a kid knows how important location is. Your investments are no different. For long-term planning, holding investments in the right �location� can make a significant difference in your portfolio�s performance. The �location� of your investment is the type of account you hold your investment in: a taxable account or a tax-deferred account such as an IRA or 401(k). A recent academic study conducted by Carnegie Mellon and University of North Carolina professors has attempted to settle the ongoing debate over which asset class (equities or fixed-income investments) is better suited for tax-deferred accounts. The study concluded that, generally, income-producing investments belong in tax-deferred accounts and equities belong in taxable accounts.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 has enhanced the importance of investment �location� planning. Consider the following advantages of holding investments as indicated in the study:

Advantages of holding equities in a taxable account:

  • Lower Tax Rate � Equities held in taxable accounts enjoy preferential tax treatment. Long-term capital gains and dividends are taxed at a maximum rate of 15%, compared with a maximum rate on ordinary income of 35%. In addition, gains can be deferred until the investments are sold. If you hold equities in your tax-deferred accounts, all income is deferred until you make withdrawals. However, you pay tax on your withdrawals at your ordinary income rate. This means that you lose the preferential tax treatment on your gains and dividends.
  • Realizing Losses � You can use losses on your investments to offset gains, and to some extent other income, if the assets are held in taxable accounts. Generally, equities experience more price volatility than fixed income investments. Therefore, holding them in taxable accounts may create opportunities to claim realized losses resulting in lower taxes.
  • Stepped-up Basis � If appreciated securities are held until death, heirs can benefit from a step-up in basis. (Step-up in basis is a reset of cost basis equal to the value of the securities at the date of death.) Assets held in a retirement account are not eligible for a step-up in basis. Since, over the long term, equities experience more price appreciation than fixed income investments, your heirs could benefit greatly from holding equities in your taxable accounts.

Advantages of holding income investments in tax-deferred accounts:

  • Deferral of Taxes � This means the income produced from income-oriented investments � bonds, Real Estate Investment Trusts (REITs), Limited Partnerships (LPs), or bond funds � will compound tax-deferred until you withdraw the money. This strategy could provide significant current tax savings where an investor does not need the current income generated from his or her fixed income investments.
  • Lower Tax Rate � By holding fixed income securities in a tax-deferred account you may pay tax on the income at a lower tax rate. When you hold income investments in a taxable account, you pay tax on the income at your current income tax rate. If instead you hold income investments in a tax-deferred account, you pay tax on that income when you make withdrawals. If withdrawals occur in retirement, when your tax rate may be lower, you effectively pay less tax on the same income.Despite the advantages of this location strategy, other factors, such as income needs from your investments, diversification issues, and the size of each account type, may dictate a different approach.

    We can help you determine the optimal location of your investments based on your individual circumstances. Call us to set up a free initial consultation with one of our advisors.