Asset Location - Increase Investing Returns & Reduce Your Taxes

Location - Once the Holy Grail for real estate investors is fast becoming the mantra for every stock, bonds, mutual fund and investors. Experts and studies hours recognize the asset management position is second only to asset allocation in determining the success of your investment returns.

Importance of Asset Location:

Asset location is a cornerstone of success for a simple reason. Taxable accounts other than tax deferred accounts (401 (k), IRA or similar retirement). Taxable accounts require you to pay income tax on any dividends and capital gains generated from your investment. This tax substantially reduces the amount of reinvestment and annual growth of investment. On the other hand, retirement accounts defer taxes allowing returns to compound without penalty and a significantly faster rate. Asset location refers to the optimal placement of securities between taxable and tax deferred accounts. Good choices reward investors with long-term compounding and significantly higher returns. Wrong choices, or more commonly, not choice, leads to results below average.

The effects are striking. Investors lose up to 20% of their after tax returns from investments in mislocating the wrong type of account. So says a recent study by three professors of finance and Dammon Robert S. Chester Spatt, of Carnegie Mellon University, and Harold H. Zhang of the University of North Carolina. The professors analyzed two classes of assets, equities and bonds in order to determine the suitability for investment by tax deferred accounts. Their conclusion? Investors should keep in equities and bonds taxable accounts tax deferred accounts, to the greatest extent possible. Younger investors stand to gain most from one to follow this advice. Three of the most powerful elements of investing - dividends, taxes deferred, and compound interest - for a staggering combined effect of retirement income.

Unfortunately, the typical investor does not exercise all three performances. A recent Federal Reserve survey shows Americans invest their taxable and tax deferred accounts with identical securities. People focus on individual accounts, rather than the entire portfolio. They ignore the benefits of distribution of investment among different accounts and wind with all the different accounts holding the exact same thing. To their detriment, nearly half of all investors own bonds in taxable accounts and stocks in tax deferred accounts.

Why position works:

The efficiency of the tax system is more important than ever. Two recent changes have led good position strategy. Last year the tax cut, growth and employment Tax Relief Reconciliation Act of 2003 reduced the top tax rates on dividends from 35% to 15%. Those dividends, however, would be taxed at ordinary rates (up to 35%) when withdrawn from the account of a retirement. The new law further cut taxes on capital gains from 20% to 15%. Since most equity investments generate returns from both dividends and capital gains, investors realize lower tax bills when holding stocks or mutual funds for capital within a taxable account.

Similarly, fixed-income investments (eg, bonds) and real estate trusts generate a regular flow of cash. These interest payments are subject to the same ordinary income tax rates to 35%. A tax deferred retirement account provides investors with the best possible reception for these securities and their resulting profits.

Investment that goes where?

Fortunately, the resource position strategy may be relatively simple. Place highly taxed in deferred tax assets accounts first. Anything left over can go into the taxable accounts. From the academic study, the professors concluded with three general rules to help with decision-making. First, locate taxable bonds, real estate investment trusts (REITs) and its mutual funds in tax deferred accounts. Second, identify actions and funds for capital investment in taxable accounts - even if you're an active trader and generate substantial short-term gains. Third, never buy a municipal bond to fill completely tax deferred accounts with taxable bonds or REITs. The combination of composition and defer taxes on the higher returns of corporate bonds is. If all this sounds a little 'of overwhelming, just consult the table below.

Table 1: Asset Locations of high performance and low fees.

TAXABLE ACCOUNTS

- Stocks

- Tax-free or tax deferred bonds (munis, treasuries, and savings bonds)

- Mutual funds that invest in stocks or bonds tax favorites

TAX-DEFERRED ACCOUNTS (IRAS traditional 401 (k) s and deferred annuities)

- Taxable bonds (firms, zeros, suggestions and high yields)

- REIT (Real Estate Investment Trusts)

- Mutual funds that invest in bonds or taxable REIT

Two exceptions are noteworthy. First, qualified distributions are tax-free Roth IRAS. Generally, the activities occur with the greatest potential of return within a Roth. Secondly, if a 401 (k), IRA or holds all (or nearly all) your investment money, throw away this article focus on asset allocation.

Subject:

You, as an investor, can take control over taxes and expenses related to your investment returns. Give your investments to reduce risk and increase returns. Locate your investment with the management of all your accounts to minimize the tax drag on financial performance.

Tim Olson

TheAssetAdvisor.com

Mr. Olson is the editor of The Asset Advisor, a financial investment service providing proven strategies for no-load mutual fund investors. He brings 26 years of education and experience from Stanford University, Ernst & Young financial consulting, personal wealth management, and venture capital investing.

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