Asset location is an important, but often misunderstood investment strategy. Physicians are high-income earning professionals, which puts them in a unique position of having more disposable income than the average American taxpayer.
As such, you may have more income to invest. In fact, investing may be a cornerstone of your wealth management and financial planning.
But investing on its own isn’t enough. The right investment strategy can help you optimize your existing portfolio, leverage tax benefits, and maximize your expected returns.
Asset location strategy is important for physicians because it can help them make the most of their income while also supporting long-term financial goals.
Keep reading to find out more about asset location strategy, how it works, and the ways in which it might be able to help you take control of your tax liability.
What is an Asset Location Strategy?
Asset location strategy is an intentional effort to reduce your tax burden while still making investments. Like asset allocation, it will require forethought to put your investments into a variety of accounts with the understanding of how the tax treatment will affect your eventual return.
If you ever buy or sell new assets, rebalancing your portfolio with tax efficiency in mind can have a significant impact on your returns.
Tax-efficient assets can be placed anywhere, but tax-inefficient assets are best placed in a tax-deferred or tax-exempt account.
Asset Location Example
To illustrate, let’s walk through an example.
A single physician has a traditional IRA with $100,000 invested in a total stock market index fund.
- $60,000 is made up of her contributions
- $40,000 is made up of gains
If she withdraws all $100,000, she will owe ordinary income tax on all $100,000 of the distribution because she has never been taxed on this money.
With the 2023 marginal tax rates, her total tax bill would be $18,079 (ignoring deductions and credits). She’s left with $81,921.
On the other hand, if she held this $100,000 in a taxable brokerage account with the same $60,000 of contributions and $40,000 of gains, she would only owe tax on the $40,000 gain and the tax rate would be one of the more favorable capital gain rates.
Let’s assume she is in the 24% tax bracket, so her capital gain rate would be 15%. In this case, she would pay a total tax of $6,000 (.15 x $40,000), leaving her with $94,000 to spend.
In this second scenario, we also have to take into consideration the tax she paid on the $60,000 of contributions she put into her taxable brokerage account.
The amount of tax she paid on the $60,000 worth of contributions will depend on the tax rates when she contributed it, but if we use the 2023 marginal tax rates, she will have paid $8,990 in tax on the $60,000 of contributions.
This brings her total tax in the taxable brokerage account scenario to $14,990 leaving her with a total of $85,010. This is a little over $3,000 difference by investing tax efficiently.
Please note that this is a simplified example, and many factors go into your asset location strategy.
Why is Asset Location Strategy Important?
Asset location strategy is important because it has the potential to lower your tax bill. Tax efficiency leaves you more room to set aside money to thoughtfully plan for retirement and build equity in other areas of your life, like purchasing a home.
Asset location is a crucial part of maintaining a diversified investment portfolio.
Minimizing tax liability is also important as you near retirement because it leaves you with more money to subsidize fixed income from social security and other retirement income streams.
Asset ALLOcation vs Asset LOcation
Your asset allocation is the diversity of your investments typically represented by a percentage based on the different asset classes in your portfolio.
Commonly, when you are younger, you will have a more aggressive asset allocation, meaning you will hold more growth-oriented investments such as stocks.
For example, if you have $200,000 in stocks and $300,000 in bonds, your asset allocation would be 40% stocks ($200,000/$500,000) and 60% bonds ($300,000/$500,000).
As you near retirement, your asset allocation typically will become more conservative and may switch to a higher percentage of bonds than stocks. Asset allocation is based on your own goals, time horizon, and risk tolerance.
Your asset location strategy, on the other hand, is where you hold a specific investment. You can hold investments in a pre-tax retirement account, post-tax retirement account, or a taxable brokerage account.
The key to your asset location strategy is understanding how different investments are taxed and what that means for your tax bill when you hold them in the different accounts available to you.
Bonds are taxed differently than stocks which are taxed differently from real estate investment trusts (REITs), and by having a tax-efficient asset location strategy, you can invest these assets in the vehicles that will save you the most on your taxes.
Differentiating Asset Location and Asset Allocation
Physicians are paid an average of $250,000 per year, which is far above the national average of about $60,000.
When you are earning a high income, it is important to understand the difference between an asset location strategy and an asset allocation strategy.
Asset Location and Asset Allocation are both important aspects of an investment portfolio.
Asset Allocation will help you diversify your investments while asset location will help you invest as tax efficiently as you possibly can.
Every physician’s situation is different, and investing diversely and tax efficiently requires looking at multiple factors such as your risk tolerance and investing time horizon.
In summary, hold tax-efficient assets such as stocks and index funds in taxable accounts and tax-inefficient assets such as bonds in pre-tax accounts, and don’t forget to consider how the net investment income tax plays into your situation.
Knowing the basics of how to invest tax efficiently could save you thousands of dollars in unnecessary taxes.
Understanding the Different Types of Investments
There are virtually endless types of investments and the best investment strategy is diversification.
In other words, investing in a variety of different types of assets is the key to protecting your funds while also maximizing your leverage in the market at any time.
Choosing the right assets for your needs will depend on your investment objectives, risk tolerance, and the cost-benefit analysis of pre-tax returns and after-tax returns.
This list is far from exhaustive, but many assets on the market can fit into one of the following categories:
- Stocks: Stocks are a share of a private company. Stock owners receive dividends on their shares based on the company’s earnings and assets. Stocks can carry more risk than other types of investments because the company can go under or lose value over time.
- Bonds: Bonds are a loan to a company or government body. Once the bond matures, the borrower pays back the original amount with interest. Bonds aren’t as risky as stocks, but they may have lower returns.
- Mutual funds: Mutual funds are a pool of money from many investors supervised by professional money managers. The money managers purchase a large share of bonds and stocks on behalf of investors and then pay out dividends and interest. You can choose a mutual fund based on your risk tolerance and financial goals.
- Index funds: Index funds are a type of mutual fund, but they’re not supervised by a money manager who trades on investors’ behalf. Instead, it passively tracks a given index. Index funds tend to cost less than mutual funds because they’re not paying for a manager.
- Exchange-traded funds (ETFs): ETFs are a type of index fund. ETFs can be a great option for investors who want a more active role in trading because they can buy and sell stocks throughout the day.
- Options: Options are contracts that lock in a price for a stock or bond that’s set to be sold on a given date. Options offer flexibility because investors don’t actually own the stocks until the agreed-upon date. As such, investors can choose to buy or sell the stock by the date, sell the contract, or let the contract expire.
Understanding the different types of investments, asset classes, and where to hold them is the key to implementing a strong asset location strategy.
How Are Different Asset Classes Taxed?
Coming up with a good asset location strategy starts with understanding how different asset classes are taxed, how short-term capital gains are taxed, and how long-term capital gains are taxed.
How are Short-Term Capital Gains Taxed?
Short-term capital gains are taxed at your normal, ordinary income marginal tax rate. A gain is considered short-term if you sold an asset after holding it for one year or less.
So if you are in the 35% marginal tax bracket, hold a stock for less than a year, and sell it for a gain, you will pay a 35% tax on that gain.
The same goes for selling most other assets for a gain including bonds, REITs, and even your residence.
How are Long-Term Capital Gains Taxed?
Long-term capital gains are taxed more favorably.
There are three long-term capital gain tax rates: 0%, 15%, and 20%. The tax rate you pay on a long-term capital gain depends on your marginal tax bracket and filing status.
A gain is considered long-term if you held the asset for more than a year before selling it.
How are Stocks Taxed?
Stocks, mutual funds holding stocks, and passive index funds tracking a stock index can be taxed in a multitude of ways.
First, stocks typically pay dividends on a semi-regular basis. When a stock pays a dividend, the dividend is either considered a qualified dividend or a non-qualified dividend.
- Qualified Dividends: You pay tax on qualified dividends at the more favorable long-term capital gain rate.
- Non-Qualified Dividends: You pay tax on non-qualified dividends at your normal, ordinary income marginal tax rate.
You will also pay taxes related to stocks when you sell them. If you hold a stock for the short term and sell it for a gain, you will pay ordinary income tax on the gain.
If you hold a stock for the long term and sell it for a gain, you will pay the more favorable long-term capital gains tax on the gain.
How are Bonds Taxed?
Like stocks, bonds can be taxed in multiple ways.
Bonds generate regular cash flow by paying the bondholder interest. Interest is considered ordinary income, so when you receive interest from a bond, you will pay taxes on the interest at your ordinary marginal income tax rate.
You can also sell bonds for a capital gain or loss. Like stocks, if you sell a bond for a short-term gain, you will owe tax at your ordinary-income rate. If you sell a bond for a long-term gain, you will owe tax at the more favorable long-term capital gain rates.
Bonds are a bit more nuanced because of the different types of bonds out there. For example, interest paid by government bonds is taxed at the federal level, but not at the state and local level.
Municipal bonds are not taxed at the federal, state, or local level as long as you reside in the state where the municipal bond was issued.
Generally speaking, though, bond interest is taxed as ordinary income, and this will play into how you select your asset location strategy.
What is a bond fund?
A bond fund is a mutual fund that invests solely in bonds. The fund will typically invest in a variety of different types of bonds, including government, municipal, corporate, and convertible bonds.
Like mutual funds, the investment objective is to generate monthly income for the owners of the bonds.
Bond funds allow investors to buy and sell bond shares every day based on market conditions.
Like mutual funds, investors can choose a bond fund that matches their risk tolerance. Some bond funds are more conservative and they are more likely to invest in government bonds, which are guaranteed but have less competitive interest rates.
Other bond funds are more riskier, but they may have a greater potential for return on investment.
Where can I hold my bond funds?
As a general rule, tax-sheltered accounts are the better place to hold bond funds, but that only works if you don’t need to access to bond funds for liquidity reasons.
There are two ways to make money on bond funds. Most commonly, you can hold onto bonds until they reach their maturity date while collecting interest. You can also sell bonds at a price higher than you paid to earn a profit.
What is the difference between tax-free and taxable bonds?
The difference between tax-free and taxable bonds is the tax liability. As the name suggests, tax-free bonds are excluded from
Tax-Efficient vs. Tax-Inefficient Assets
When thinking about an asset location strategy, it is also important to understand the difference between tax-efficient assets and tax-inefficient assets.
Tax Efficient Assets
An investment is considered tax efficient if it doesn’t generate ordinary taxable income regularly. For example, stocks held for the long-term and passive index funds such as an S&P 500 index are considered tax-efficient investments.
Stocks and index funds typically pay dividends every quarter, and these dividends are usually considered qualified dividends. If a dividend is qualified, that means you pay tax on the dividend at your more favorable long-term capital gain rate.
Stocks held for the long term are also considered tax-efficient because when you sell a long-term asset, you pay tax at the long-term capital gain rate.
Notice how you are not paying your ordinary income tax rate in either of these situations, and you are only paying tax when you sell the stock for a gain or when you receive a dividend.
Tax Inefficent Assets
A tax-inefficient investment is one where you will be paying taxes at your ordinary income tax rates for the income the asset generates regularly. Examples of tax-inefficient investments include bonds, actively traded, high-volume mutual funds, and REITs.
Bonds are considered tax-inefficient because they pay you interest on an annual basis, and the interest is considered ordinary income.
This means bond interest is taxed at your marginal tax rates, so if you are a physician in a high marginal tax bracket, you will be paying a high tax rate on your bond interest, and you will be paying it annually.
When mutual funds are traded frequently, they generate tons of short-term capital gains or losses because the fund is not holding assets for a period longer than one year.
Short-term capital gains are taxed at your ordinary-income tax rate, so if a mutual fund is trading frequently, you likely will be paying tax more frequently than you need to.
REITs pay dividends to their unitholders and are considered tax inefficient because these dividends are typically considered ordinary income which means you will pay tax at your ordinary income rate.
Asset Location Strategy for Physicians
The type of account you hold an asset and invest it has a direct relationship to your tax efficiency.
You can invest in a pre-tax retirement account, post-tax retirement account, taxable brokerage account, or other non-retirement taxable vehicles such as holding government bonds.
Each account has its advantages and disadvantages, especially when it comes to investing tax efficiently.
Hold Tax Inefficient Assets in Pre-Tax Retirement Accounts
When you invest in a pre-tax retirement account, you defer paying taxes on your income until you withdraw the money at a later date. Decreasing your current taxable income is a great way for high-income earning physicians to reduce their current year taxes.
Another advantage of investing in pre-tax accounts is when you trade in them, you don’t pay taxes on any gains, dividends, or interest until you withdraw the assets upon retirement.
So what does this mean for your asset location strategy?
Remember, tax-inefficient assets are ones where you pay ordinary income taxes regularly due to a regular stream of income such as bond interest.
This makes bonds a great investment to hold in pre-tax retirement accounts. Since bonds generate interest every year, you would normally have to pay tax on that interest at your normal, ordinary income tax rate.
However, if you hold bonds in your pre-tax retirement account, you don’t pay tax on the annual interest until you withdraw the money upon retirement.
The same goes for if you sell a bond before retirement. If you sell a bond for a gain in your pre-tax retirement account, you don’t have to pay tax on that gain until you withdraw the money in retirement.
So why not invest in stocks in your pre-tax retirement account?
Nothing is absolute when it comes to investing, so having stocks in your pre-tax retirement account is also a good idea. If we are thinking about it from a pure tax efficiency perspective, bonds are generally the better option to hold in your pre-tax accounts.
Your ordinary income tax rate is going to be higher than your capital gain rate. As we have seen, bond interest is taxed at your ordinary income tax rate while stock dividends are taxed at your long-term capital gain rates.
That means you will be paying a higher tax rate on bond interest, so you should hold that in an account that you don’t pay tax on frequently.
Hold Tax Efficient Assets in Taxable Accounts
The money you invest in a taxable brokerage account has already been taxed once when you received your paycheck or paid taxes on your 1099 income.
That is why it is important to invest as tax efficiently as possible within your taxable accounts. If you invest in bonds in a taxable account, you will pay ordinary income tax on the annual interest. This is not tax efficient.
What are the benefits of using a taxable account?
Investing in stocks in your taxable accounts is tax-efficient. Income from your stock investments is taxed when the stock distributes a dividend or when you sell the stock for a gain.
Dividends are typically qualified dividends, meaning you only pay tax on those at the more favorable long-term capital gain rates. As long as you hold your stock for longer than one year, if you sell it for a gain, your gain will also be taxed at the more favorable capital gain rates.
What Are After-Tax Retirement Accounts?
After-tax retirement accounts such as a Roth IRA are a mixed bag. Since the dollars you are putting into a Roth IRA have already been taxed, and there is no tax on the contributions or gains when you pull the money out at retirement, there is no one size fits all strategy here.
Bonds will do better in a Roth than in your taxable brokerage account because you will never owe taxes on the annual interest. Stocks will also do well in a Roth account because the dividends won’t be taxed.
Any capital gain you achieve from a Roth account won’t be taxed either. Investing in a Roth account would be tax efficient with both asset classes, however, many physicians won’t be able to invest in a Roth account unless they perform a Backdoor Roth Conversion.
Roth IRA vs Traditional IRA
The difference between a Roth IRA and a traditional IRA is how each account is taxed.
Roth IRA
With a Roth IRA, you contribute after-tax dollars and your investments grow tax-free, meaning you won’t have to pay tax on the interest or withdraw amounts after you’ve reached 59.5 years old.
Traditional IRA
With a traditional IRA, you can contribute pre-tax or after-tax dollars from your income and the funds will accrue tax-deferred interest. However, withdrawals will be taxed as current income after you are 59.5.
Both retirement accounts have pros and cons, but there are also some workarounds to make the most of your tax deductions and future retirement planning.
How Backdoor Roth IRA Conversions Tie Into Asset Location Strategies
A backdoor Roth IRA conversion is a method of converting your pre-tax investments into after-tax investments in a Roth IRA.
While the process is fairly straightforward – the tax implications are not.
The purpose of a Backdoor Roth IRA is to allow high-income earners who normally aren’t able to save into a Roth IRA directly, a way to get money into one. It technically is a legal way to get around the income limits on contributing to a Roth IRA.
To accomplish a Backdoor Roth IRA, you’ll first save into a Traditional IRA, with pre-tax funds. This is then converted into a Roth IRA with the assistance of the brokerage that holds the account. You’ll pay taxes on the contributions and any growth, but after the conversion, the funds grow tax-free.
Once converted, a new distribution rule is added to the converted funds – the five-year rule which places additional penalties on distributions within five years of converting with limited exceptions.
Once in retirement, the Roth IRA is the only retirement savings account that does not have Required Minimum Distributions (RMDs).
Getting money into a Roth IRA can help diversify the types of accounts you have to pull from once in retirement – creating additional withdrawal strategies.
How Does Net Investment Income Tax Play Into Your Asset Location Strategy?
Another thing to consider as a high-income earning physician is the net investment income tax (NII).
The NII is an additional 3.8% tax on your investment income if your modified adjusted gross income is over $200,000 for Single filers and $250,000 for married filing jointly filers.
When your income is over these amounts, you will owe a 3.8% tax on the lesser of your net investment income or the excess of your MAGI over the threshold amount.
The IRS defines investment income as interest, dividends, capital gains, rental income, royalty income, and non-qualified annuities.
The implications for physicians are if you make more than the thresholds noted above, and you receive taxable investment income during the year, then you will owe a 3.8% tax on that investment income.
This is where asset location can help. Investing in pre-tax retirement accounts, whether that is stocks or bonds, will shield the income from these investments from the net investment income tax during your working years.
When you withdraw the funds upon retirement, there is a good chance you will be withdrawing less than the thresholds for the NII, so you will avoid the NII altogether.
Frequently Asked Questions
What is tax-loss harvesting?
Tax-loss harvesting is a strategy of selling investments at a loss to offset capital gains on other investments. Tax-loss harvesting is most effective when you use the funds from selling investments to reinvest, so you still have a diversified portfolio.
When it’s done right, tax-loss harvesting will reduce the current year’s tax bill. When you owe less money in taxes, you’ll have more money left over to make prudent investments or enrich your life in other ways.
What are tax-advantaged accounts?
A tax-advantaged account is any type of investment that offers tax benefits, such as deferred taxes and exemptions.
The following accounts have tax advantages:
- Traditional 401(k)
- 403(b) and 457 plans
- Traditional IRA
- Roth 401(k), 403(b), 457 plans
- 529 plan
- Health savings account
- Municipal bonds
- Charitable giving
What is the difference between a tax-advantaged account and a taxable account?
A tax-advantaged account protects investments from losing returns while they’re still growing because investors will pay taxes when they withdraw the funds.
Tax-advantage accounts, such as traditional 401(k)s and IRAs, have specific age limits investors must reach before they’re able to access the funds without penalty.
A taxable account will require investors to pay taxes on any interest or capital gains they earn, but they’ll be subject to fewer restrictions and more withdrawal flexibility.
What is tax efficiency?
Tax efficiency is a financial planning strategy to maximize tax deductions so investors are on the hook for less tax.
Working with a financial advisor can help you make sure you’re making the most tax-efficient investments available to you.
What is the tax treatment on mutual funds?
The tax treatment on mutual funds is that you must report any time you bought or sold shares throughout the year. You’ll need to pay taxes on any capital gains or dividends you earned throughout the year.
You may also have a tax liability if the mutual fund realizes any gains, even if you haven’t bought or sold any shares that year.
