The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments

Chapter 10. The Asset Location Decision

When faced with a choice of locating assets in either taxable or tax-advantaged accounts, taxable investors should have a preference for holding equities (versus fixed-income investments) in taxable accounts. But regardless of whether they hold stocks or fixed-income investments, investors should always prefer to first fund their Roth IRA or deductible retirement accounts (IRA, 401k or 403b) before investing any taxable dollars. Because tax-advantaged accounts are the most tax-efficient investment accounts, investors should always take maximum advantage of their ability to fund them. The one exception is the need to provide liquidity for unanticipated funding requirements.

There are six advantages to holding equities rather than fixed income in a taxable account:

• Equities receive capital gains treatment while fixed-income investments are taxed at ordinary income tax rates. At least as of this writing, qualified dividends are taxed at a preferential rate.

• Securities in taxable accounts receive a step-up in basis for the heirs at death, eliminating capital gains taxes, though not the estate tax. On the downside, securities with unrealized losses in taxable accounts receive a step-down in basis at death—a good reason to harvest losses when available.

• Capital gains taxes are due only when realized. Investors have some ability to time the realization of gains. In addition, the advent of core funds, tax-managed funds, and exchanged-traded funds (ETFs) ...