Location! Location! Location!
That’s a phrase you often hear related to real estate. But it could also be applied to the world of investments.
Assume you have two different financial accounts for investing. The first is a traditional IRA that you make deductible contributions into each year for a retirement fund. Any income earned in that account is deferred until the time you withdraw the funds.
The second account is a regular investment account, or taxable account. Income earned in this account flows through to your personal tax return at the end of the year. And you don’t get a tax deduction for contributing to this type of account.
Now suppose you are considering buying two investments: a Murphy Oil bond paying five percent interest and shares of Murphy Oil common stock currently trading at $25 and paying a dividend of 50 cents per year. Does it matter which account holds which investment? You bet it does and let’s look at why this is.
When you pull funds from your traditional IRA, those distributions will be taxed at ordinary income tax rates. Depending on your income level, those rates can be as high as 37 percent at the federal level. Then figure another 6 percent maximum for Arkansas income tax. (As a side note, the first $6,000 of retirement income is excluded from taxation in Arkansas.)
Suppose I put the Murphy stock in my IRA account. I buy the stock at $25 and years down the road it’s trading at $45. So I sell the shares and pull the funds from the IRA. What I have described here is a long-term capital gain, an investment held for more than a year. And long-term capital gains rates are significantly lower than ordinary income tax rates, maxing out at 20 percent at the federal level and 3 percent effectively at the state level.
But remember that comment about distributions from an IRA being taxed at ordinary income tax rates. So even though my gain on Murphy stock looks like and smells like a long-term capital gain, it doesn’t get capital gain tax rates because of the type of account in which it’s held.
But if I had held the stock in my taxable account, the $20 gain would have qualified for long- term capital gains taxation. In addition, that 50-cent dividend, if it meets certain holding period criteria, also qualifies for capital gains taxation if held in the taxable account. But it, too, will come out as ordinary income if held inside the IRA.
Now assume that, instead of putting Murphy stock in my IRA, I buy the Murphy bond inside the IRA account. Interest on corporate bonds is taxable at the federal and state levels at ordinary income tax rates. So, the interest on the Murphy bond is going to be taxed at ordinary rates whether I hold it in the IRA or in the taxable account. The difference is, in the IRA I don’t pay taxes until I withdraw the funds. In the taxable account, I have to pay taxes on the interest every year.
I realize this discussion may be creating a taxing headache for you. But when you consider that most of us need to hold a combination of stocks and bonds in our portfolio, this process of asset location can add up to significant tax savings. Research from mutual fund giant Vanguard estimates that proper asset location practices can add up to three fourths of a percent in after-tax returns.
Given that the national average rate on one-year CDs is currently about a half percent, that’s significant savings!
Dr. David Ashby is a Certified Financial Planner and the retired Peoples Bank Professor of Finance at Southern Arkansas University. He holds degrees in accounting and business administration and a doctorate in finance from Louisiana Tech.