Location! Location! Location!
You often hear this phrase in connection with real estate. But it could also be applied to the world of investing.
Suppose you have two different financial accounts to invest in. The first is a traditional IRA into which you pay deductible contributions to a retirement fund every year. All earnings in this account will be postponed until you withdraw the funds.
The second account is a regular investment or taxable account. The income generated on this account is included in your personal tax return at the end of the year. And you won’t get any tax deduction on contributions to this type of account.
For example, let’s say you’re considering buying two investments: a Murphy Oil bond with five percent interest and shares of Murphy Oil common stock that currently trade at $ 25 and pay a dividend of 50 cents a year. Does it matter which account holds which investment? You can bet on that and let’s see why that is.
If you withdraw funds from your traditional IRA, those distributions will be taxed at normal income tax rates. Depending on your income level, these rates can go up to 37 percent at the federal level. Then add another 6 percent maximum to Arkansas income tax. (As an aside, the first $ 6,000 of retirement income is non-taxable in Arkansas.)
Let’s say I deposited Murphy stock into my IRA account. I buy the stock for $ 25 and years later it trades at $ 45. So I’m going to sell the shares and get the money from the IRA. What I have described here is a long-term capital gain, an investment that will be held for more than a year. And the rates for long-term capital gains are significantly lower than the usual income tax rates and are a maximum of 20 percent at the federal level and effectively 3 percent at the state level.
But remember that comment that distributions from an IRA are taxed at normal income tax rates. While my Murphy stock profit looks and smells like a long-term capital gain, it does not receive capital gains tax rates due to the type of account it is held in.
However, if I had held the stock in my taxable account, the $ 20 gain would have qualified for long-term capital gains tax. In addition, if this 50 cent dividend meets certain criteria for the holding period, it also qualifies for capital gains tax if it is held in the taxable account. But it too will come out as normal income if kept within the IRA.
Now let’s say that instead of putting Murphy stock in my IRA, I buy the Murphy bond within the IRA account. Interest on corporate bonds is taxable at the federal and state level at the ordinary income tax rates. So interest on the Murphy bond is taxed at normal rates whether I hold it with the IRA or in the taxable account. The difference is that in the IRA I don’t pay taxes until I withdraw the money. I have to pay tax on the interest in the taxable account every year.
I understand that this discussion may give you a headache. However, when you consider that most of us need to hold a combination of stocks and bonds in our portfolio, this wealth discovery process can result in significant tax savings. Research by mutual fund giant Vanguard estimated that proper asset location practices can account for up to three quarters of a percent of after-tax returns.
Given that the nationwide average price for annual CDs is currently around half a percent, that’s a significant saving!
Dr. David Ashby is a Certified Financial Planner and a retired People’s Bank Professor of Finance at Southern Arkansas University. He holds degrees in accounting and business administration and a PhD in finance from Louisiana Tech.