When clients have both tax-advantaged and taxable accounts, planning involves not only asset allocation but also asset location, making advisers consider what goes where.
“Assets that generate more ordinary income, such as taxable bonds and bond funds, may be better in [individual retirement accounts],” says Jessica Hovis Smith, a CFP and the vice president and director of financial planning at Longview Financial Advisors in Huntsville, Ala.
Interest and dividends are sheltered from tax until withdrawal.
“Assets that receive long-term capital gain tax treatment and pay little to no ordinary income, such as growth stocks, are best in taxable accounts,” Smith says.
There may be scant annual tax, and any gains on sales might be taxed at favorable rates.
OUTSIDE THE BOX
Not every asset will fit neatly into this design. Some stocks pay qualified dividends, eligible for low tax rates.
“High-dividend-paying stocks may be good for a taxable account if they will be held long enough to get the preferential tax treatment and are not frequently traded,” Smith says.
Moreover, real estate investment trusts and master limited partnerships can distribute ordinary income as well as untaxed returns of capital.
“REITs do throw off ordinary income, which would make you think an IRA might be a good option, but some generate unrelated business taxable income, which can create taxes within an IRA,” Smith says.
“When we’ve used REITs, we’ve primarily invested in retirement accounts due to the high dividend rates and the taxable nature of the income,” she says. “We have not invested in REITs that create UBTI issues.”
As for MLPs, Smith recommends using taxable accounts because they offer some tax benefits.
“However, investing directly in MLPs can create a tax headache, with investors receiving K-1 forms, which could cover several states,” she says.
“We have used an MLP mutual fund. These tend to have lower returns because they are not 100% invested in MLPs, but income is reported on a Form 1099 and UBTI usually is not an issue,” Smith says.
HEALING THE HEADACHE
Paul Gydosh, a CFP and managing director at Kensington Wealth Partners in Columbus, Ohio, thinks that some of the headaches involved in holding K-1 assets may be alleviated by using IRAs.
“Clients detest getting their K-1s late because most people want to file their tax returns by April 15,” he says. “A K-1 might not arrive until just before or even after the deadline, forcing a filing extension.”
Many types of investments generate K-1s.
“That happens with hedge funds and managed futures funds, while separate account managers may have some client money in K-1 assets,” Gydosh says.
Some ETFs -- commodity, currency or volatility, for example -- also will send out K-1s. (As mentioned, IRA investments requiring K-1s might generate UBTI, if over certain income thresholds.)
“If the K-1 assets are in an IRA, clients can file tax returns on time and reduce anxiety,” Gydosh says.
“Conversely, some clients will be in partnerships that could produce losses and therefore should be in taxable accounts,” he says. “Advisers should recognize those nuances when determining what goes where.”
This story is part of a 30-30 series on ways to build a better portfolio.