It might seem obvious that the best performing car isn’t just a function of the car itself…but also WHERE you’re driving it.
Ferraris vs. Hummers will perform best in very different environments.
When it comes to asset management, a similar thing is true.
To maximize total after-tax returns, WHERE you hold your assets is just as important as WHAT assets you hold.
Asset allocation is WHAT you hold.
Asset location is WHERE you hold it.
You have to make sure you drive the Ferrari vs. the Hummer on appropriate terrains.
Asset location strategy is about holding the right asset classes in the right accounts bearing the right tax profile.
The goal is to minimize taxes on the way in, minimize tax drag while you invest, and minimize tax liability upon withdrawal.
How do you do this?
This week, I talk with Jonathan Duong, CFA, about how to manage your asset location to be as tax-efficient as possible. (This is part 1 of a 2-part discussion.)
In addition to best practices and general principles, we discuss optimal asset location for:
- Stock holdings (both indexes and individual stocks, both dividend and non-dividend paying)
- Non-tax exempt bond holdings
- Tax-exempt bonds
- Physical real estate
What asset location principles are most relevant to you? Let me know by leaving a comment.
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Links mentioned in this episode:
- Wealth Engineers
- Financial planning software: eMoney, Advyzon, Covisum
- How to set your target asset allocation and rebalance your portfolio efficiently (HYW058)
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:23
My guest today is Jonathan Duong.
I had Jonathan on the podcast a few months back, where we talked about how to select the best index funds, which folks found insightful, thankfully. But there’s a related topic to fund selection, around asset location – which is about where it’s most advantageous and tax-efficient to hold different asset classes.
So I invited Jonathan back to the podcast today to share tips and insights about this critically important topic.
If you want to make sure your investments are optimally allocated from a tax and withdrawal strategy perspective, then you definitely want to tune in to today’s episode.
Quick background on Jonathan:
He is the President of Wealth Engineers, a Denver-based fee-only financial planning and wealth management consultancy that is focused on low-cost asset management.
He previously served as the director of investments for another Denver-based wealth management firm. And he also worked in Ernst & Young’s Transaction Advisory Services group, where he focused on advising corporate and high net worth clients on investment, tax, and planning issues. He holds both the CFA and CFP designations.
Jonathan, thanks so much for joining us today to share insights about asset location!
Jonathan Duong 02:27
Yeah, good to be here. I’m glad to have the conversation again. I think it’s a really good follow-up from our last discussion.
Andrew Chen 02:33
Cool. For those folks who aren’t familiar, maybe they didn’t catch the last episode, just really briefly, what type of financial planning do you do? What makes your approach different?
Jonathan Duong 02:46
We’re going to try to cover a lot of ground today, and I think a good preface for that is just our approach when it comes to working with our clients. It is very tax-centered and very tax-focused.
We’re a fee-only registered investment advisory firm based in Colorado. We tend to work with clients who certainly oftentimes are high income-earning or high net worth, or both, so tax planning and tax strategy is very central to what we do.
That, of course, not only relates to portfolio design and asset selection and building a portfolio using multiple different types of accounts. Some of our clients may have five, seven, 10 different accounts between IRAs, Roth IRAs, workplace retirement accounts, trust accounts, taxable accounts, all kinds of different things, so it can tend to get fairly complicated.
So, tax planning and strategy is a big part of what we do. And we really integrate that along with all of the other considerations that somebody who’s really looking at their wealth and managing their wealth holistically needs to consider.
That’s everything from thinking about the impacts of these decisions on Medicare, on gifting or estate planning, thinking about asset protection, just a lot of different things that come into that. So this is a theme for us in terms of asset location that is very central to what we do with our clients.
Andrew Chen 04:05
Before we actually dive in, I’d love to make sure folks level set, have a shared understanding of what we even mean by asset location. When you say the term “asset location,” what do you mean exactly?
Jonathan Duong 04:23
I think it’s easy to get tripped up because in the world of personal investing, there’s two terms that are very often used. The more common term that sounds similar is “asset allocation.” Obviously, we talked a little bit about that in our last discussion.
Asset allocation predominantly being the focus of what percentage of your portfolio is broadly in stocks, broadly in bonds, and maybe you also are including commodities or real estate or other asset classes, and then what percentage of your overall portfolio is in each one of those slices. That’s what we call asset allocation.
Asset location, on the other hand, is really a concept of: now that you’ve established what your portfolio is going to look like, where do you actually buy and hold those individual securities or asset classes?
Let’s say, for the sake of argument, you’re only investing in your 401(k). Then, frankly, asset location doesn’t really matter all that much to you because you don’t have any other place to put stuff. The only place you’re putting things is in your 401(k).
There are still some tax considerations that need to be taken into account, but for the most part, you’re not really too worried, because if an asset is super tax-inefficient, it doesn’t really matter to you because you’re investing exclusively inside of a tax-advantaged account like a 401(k).
On the other hand, for an investor with a more complicated situation, you might have tax-deferred accounts like a 401(k) or a traditional IRA. You might have tax-exempt or tax-free accounts like a Roth IRA or a Roth 401(k). And then you may have taxable accounts like a trust or just a brokerage account.
And when you have multiple different buckets, then you have to decide. I like to use cooking analogies. Are you going to bake the exact same pizza in every single one of those accounts with all of the exact same ingredients?
That’s one approach. It tends to not be as preferable from a tax perspective or a transactions cost perspective when you do pay trading costs.
Or the other option being you pick and choose certain ingredients for that overall pizza. That overall pizza is your total portfolio, and you pick and choose which ingredients go where, such that each individual account is not going to look like the whole pizza, but when you add it all together as a total portfolio, then it will look like the pizza that you want.
And when we’re talking about asset location, it’s which ingredients go where when you have multiple different types of accounts.
Andrew Chen 06:50
I like the analogy. Easy to grasp.
As you alluded, there’s taxable accounts, like regular brokerage accounts. There’s deferred accounts, like 401(k)’s and IRAs. There are tax-free accounts, like Roths, even HSAs and 529s.
When it comes to asset location, what are best practices, general principles in terms of allocating different asset classes into these different types of investment accounts?
And then later, we’ll get into some specific asset classes. But I at least want to get your thoughts on a general framework, general principles, for how to do asset location thoughtfully.
Jonathan Duong 07:30
I think it does apply both in terms of an individual taxpayer’s circumstances, but it also applies based on the current environment that we’re currently in and how it compares to history.
I’ll definitely just take a quick second here to say that, obviously, none of what we’re talking about here is investment advice. You should certainly consult with your individual financial planner or financial adviser and tax adviser or legal adviser, as appropriate.
Certainly everything that we’re talking about here is pretty broad in its discussion not specific to a certain circumstance, and just recognizing within that compliance disclosure that I’m offering, part of the reason that that is so important is because all of these concepts are facts and circumstances-driven.
So, in terms of the broad discussion around, historically, what would be a rule of thumb for asset location is, generally, you want to use your tax-advantaged accounts, like an IRA, 401(k), or Roth IRA, for those assets that are less tax-efficient.
Generally speaking, that’s going to be fixed income or bonds, taxable bonds specifically, where the interest that’s earned, and obviously, at a bond, the primary component of your return is going to be interest income. It’s not going to be capital gains. So, that interest income is all going to be taxed at ordinary rates.
And in general, you want to minimize your ordinary income because that’s going to be taxed at a higher rate typically than what you’d pay on qualified dividends or long-term capital gains.
So, I’d say, throughout most of modern history, you’d want to put bonds, for example, in your tax-advantaged accounts, and you’d want to put stocks in your taxable account, as an example.
Other asset classes have a hybrid characteristic or a hybrid profile between whether they tend to be more tax-efficient like stocks or tax-inefficient like bonds. So sometimes you have a really hard decision about where an asset class goes, and that may lead you to either not investing in it at all or just accepting that it’s not an ideal tax circumstance.
So, I’d say, broadly, that’s the historical rule of thumb. What’s, of course, challenging is now being in an ultra-low yield environment. Some of those rules of thumb deserve to be challenged and reconsidered, depending on your specific tax circumstances.
But frankly, that’s something you should have been looking at or people should be looking at, in my opinion, all the time anyways. There is no single rule of thumb that’s always going to be appropriate because the tax situation for one investor versus another could be drastically different.
Andrew Chen 10:04
So, generally, less tax-efficient investments in tax-advantaged accounts. That makes total sense.
Are there any other rules of thumb that you typically advise folks?
Jonathan Duong 10:17
The framework that I encourage people to think about is, before you even talk about the specifics of an individual asset class or individual security, and there is a lot of nuance and detail that needs to be understood there, but before you even think about that level of complexity, you really just start with a few basic concepts.
You start with: How much tax-advantaged space do I have? Do I have a significant amount of IRA, 401(k) space available to me, or am I pretty limited in that regard because of my circumstances or my particular situation?
When I have more tax-advantaged space available, then I have a lot more flexibility and latitude on how to approach this, but I don’t have very much tax-advantaged space available.
We have some clients where 90% plus of their assets are in a taxable account. They just don’t have a lot of IRA space available for a variety of reasons.
The way that we approach it varies based on how much account space. What are the balances of these accounts? So, that’s the first consideration.
Second is what tax rates actually apply? You’ve got to think about: what is your ordinary income tax rate?
Are you in the 10% bracket? Are you in the 37% bracket? Those are two totally different situations, of course, when we’re thinking about how these concepts need to be actually applied and practiced.
And then, in addition to your ordinary and your long-term capital gains bracket, you also need to think about any applicable surcharges. Are you paying the net investment income tax, which is a 3.8% surcharge for investors who have incomes?
A married investor is above $250,000. A single investor is above $200,000.
Are you paying that? Because if you are, then your effective capital gains tax rate might be 23.8% as opposed to 20%. So, that’s another consideration.
You also have to consider state tax rates. That’s another complexity that comes into play.
And then, I think, in addition to that, you need to consider, as we’re thinking about the actual asset classes in investments, the yield on that investment or asset class, and whether it’s an asset class that’s going to tend to be more income-generating or it’s going to tend to be more capital-appreciating.
And all of those factors have to be taken into account when you’re making decisions about which asset classes you’re going to invest in to build your portfolio and where those asset classes and securities actually need to go.
Andrew Chen 12:36
I would love to jump into some concrete examples so folks can think about how they line up to their own portfolio and how they might treat them in an optimal way.
So, let’s start with stock holding, stock indexes, individual stocks, both the dividend-paying variety and the non dividend-paying variety. What would your general rule of thumb be for how to hold each of these?
Jonathan Duong 13:04
In general, most stock index funds, open-end mutual fund or ETF, are going to be very tax-efficient. In other words, they’re not going to tend to generate a lot of ordinary income through short-term trading or anything like that.
The majority of the dividends are going to tend to be qualified, such that they’re benefiting from the long-term capital gains rate, as opposed to non-qualified, meaning they’re going to get taxed at ordinary income rates.
Andrew Chen 13:33
And by the way, when it comes to qualified and non-qualified, how do folks tell the difference? And what is the difference?
Jonathan Duong 13:40
In terms of thinking through the difference between those, the primary difference that most investors care about is the tax rate that’s applicable. Qualified dividend is going to be taxed at long-term capital gains rates, whereas non-qualified dividends are going to be taxed at ordinary rates.
Now, non-qualified dividends can be made up of all kinds of different things. It can be interest income.
It can be distribution coming from, let’s say, real estate investment trusts. That’s not going to be able to benefit from the qualified dividend rate.
It could be any number of different things that make up that distribution, and then, ultimately, a non-qualified dividend, for example.
Primarily, investors care about the tax rate. That’s the difference between those two.
For most U.S.-based index funds, let’s say it’s a total stock market index fund or an S&P 500 tracking index fund, I’d say, in most cases, 95-100% of the dividends are going to be qualified and are going to benefit from that lower income tax rate, that long-term capital gains rate.
When you get into international and into emerging markets, if you get into mid-cap and small cap funds, particularly internationally, then that percentage can start to dip, where of a given dividend distribution from a fund, you might be looking at, say, 60-90% of that dividend distribution being qualified and the remaining part being non-qualified.
So, from a perspective of how you’re actually going to approach these things, typically what you’ll be able to do is if you already own the investments, in your custodian transaction history, they’re going to break out and tell you whether or not that was a qualified or non-qualified dividend, and so on.
If you go to your 1099, that will show even more detail. And then you can also go to the fund family website and actually see a breakout or a breakdown.
A lot of what we’re doing here at this time of year in October, November, and December, we’re actually going to the fund family’s website. They’ll typically publish a PDF or an Excel spreadsheet calculator that will actually allow us to estimate all of the year-end dividend distributions and income distributions for every fund that our clients own.
And we can then go and tabulate out what we think that their overall portfolio income picture is going to look like: between ordinary income, tax-exempt interests, qualified/non-qualified dividends, capital gains, and so on. So, all of that level of detail is there, but you’re going to have to do some work to uncover it.
Long story short, in the particular asset class we’re starting with here, for U.S. stocks, if it’s a broadly diversified U.S. stock, index fund is going to be very tax-efficient, so it’s a good candidate for considering holding in a taxable account.
At the same time, where this stuff starts to get pretty complicated, of course, is that the dividend yield right now on U.S. stocks, for example, in a lot of cases, is going to be higher than the yield on an investment grade bond fund. So you might be seeing 0.5% or 0.75% yield on a bond fund, and you might be seeing a 1.5-2.5% or 3% yield, depending on which particular stock index fund that you’re investing in.
That’s a situation where, yes, you’re getting a better tax rate on that U.S. stock dividend, because it’s going to be typically a qualified dividend, so you get a preferential rate, but you’re paying a lot more just in terms of income. It’s just a larger dollar amount of income for a given dollar of investment because the yield is higher. So, that’s where this stuff starts to get pretty tricky.
Andrew Chen 17:04
So then, let’s move on to bond holdings, both non tax-advantaged bond holdings, whether they’re indices or actual holdings, as well as tax-exempt bonds like muni bonds.
Jonathan Duong 17:19
We’ve alluded to, a little bit here, being in a low interest rate environment. In a situation where the interest income, the yield to maturity, for example, on an investment grade bond fund years ago might have been 3%, 4%, or 5%. Obviously, that can be fairly punitive for somebody who is in a higher income tax bracket.
Where if they’ve got a $100,000 investment in a given fund, if it’s got a 4% yield, that’s $4000 of ordinary income, and you might be giving up 30-40%, even sometimes close to 50%, of federal and state income tax. Blended together, that’s pretty punitive.
Obviously, now, we’re in a situation where yields are so much lower that it can sometimes make sense for investors to actually hold their bonds in a taxable account as opposed to a qualified account like an IRA or Roth IRA or something like that.
And then, when it comes to municipal bond funds, in general, the rule of thumb, of course, would be municipal bond funds are really only appropriate in a taxable account, where you’re getting the benefit of avoiding federal income tax on that interest, which is very powerful.
However, there’s no “one size fits all” situation because there have been instances in the last 12 months where the yields on municipal bonds, particularly when there was liquidity crunch right in the middle of the pandemic, where yields surged on municipal bond funds and municipal bonds in general.
So, you had a situation where the yield was so attractive that it actually made plenty of sense to hold it in a tax-advantaged account like an IRA or Roth IRA, even though you typically wouldn’t do that because you wouldn’t want to hold tax-exempt bonds in a taxable account to get that tax benefit.
So, this is a lot of if’s, and’s, or but’s, and it tends to get fairly complex. But I think the long and short of it is it really depends on your tax situation. If you’re a high-income taxpayer, you’re in a high-income bracket, typically you’re still going to want to be very mindful about holding taxable bond funds in a taxable account, and you might be better off with municipal bonds, and then holding any taxable bonds in a tax-advantaged account.
If you’re in a low-income tax bracket, it could be the opposite. It really just depends on your circumstance.
And then, we didn’t really talk about it on the U.S. stocks side, but just to offer it here as well, for bonds, we were talking about index funds. It’s also going to depend on whether it’s index or it’s active.
If it’s an actively managed fund, a lot of the implementation of an actively managed fund where there’s a lot of turnover, there’s a lot of short-term capital gains that are generated, that, in and of itself, can be the singular decision that says, “This does not belong to my taxable account because of all of this taxable activity.”
Andrew Chen 20:08
If it’s an actively managed fund, do the short-term tax consequences hit you even if it’s an ETF? I understand in a mutual fund, you might be exposed to that sort of tax drag. But in an ETF as well?
Jonathan Duong 20:23
It’s going to depend on the way that the actual implementation of this is taking place, both in structure and in the trading of the fund.
I think we talked a little bit in our last discussion around the semi-transparent and non-transparent ETFs, and the fact that the ETF structure, because it allows for in-kind redemption and some other things, it’s going to tend to be a lot more tax-efficient.
However, at the same time, you’re not going to necessarily always be able to find the exact strategy or manager that you want that has both an open-end mutual fund and an ETF. Although there are an increasing number of non-index ETFs that are available, they’re not nearly as broadly available as open-end mutual funds.
So, if you’re seeking an actively managed fund, you may find it in an ETF structure, but it’s still much more likely you’re going to be finding it in a traditional open-end mutual fund structure. And then that is where the tax issues do need to be taken into account pretty closely.
Andrew Chen 21:23
Makes sense. A moment ago, you mentioned that, given the low interest rate environment that we have right now, it might actually make sense, depending on the circumstances, to hold your taxable bond holdings in a taxable account.
Is the theory behind that just to make more room in your tax-advantaged accounts for other, say, higher-yielding assets? That’s why you sacrifice the lower-yielding asset to take it out to make more room? Is that the theory?
Jonathan Duong 21:52
I think it would be both. Yes, if you have, let’s say, a lot of Roth IRA space, then that can be a great opportunity to place your assets with the highest potential capital appreciation in your Roth IRA because that’s a fully tax-exempt account. You obviously want to let that run as long as you possibly can, given your tax situation.
Sometimes that changes a little bit, but you generally are going to let that run and grow and leave it undisturbed for the most part. So, that can be part of it.
The other part of it: just say, for the sake of argument, that you’ve got an investment grade bond fund. Let’s say it’s got a 0.5% yield. And then you’ve got a stock index fund where the dividend yield is 2.5%.
You’re in a situation there where you’ve got more than tripled the amount of income that’s going to come in the form of dividends from that stock fund compared to interest on that bond fund.
It is true that the interest coming off of that bond fund is going to get taxed at a higher rate, in most cases. It depends on your tax situation, but it is going to get taxed at a higher rate. But even though that’s at a higher rate, you’re only having a third of the amount of income, whereas on that stock dividend that’s coming out, you’re having triple the amount of it.
In other words, you might have $3 of dividends coming in for every $1 of interest for the exact same dollar amount that you actually have invested, simply because the yield is so much higher. So, it’s really both of those things.
It’s considering “How do I optimize for minimum lifetime taxation on my investments from capital appreciation and so on?” but also thinking through “Even when there’s a preferential rate, if I have triple the amount of income for that preferential rate, sometimes that may not be an ideal situation. I might rather have a third of the income even if it’s at a higher tax rate.”
Andrew Chen 23:46
Yeah, I guess it just all nets out, right? You’ll have a higher tax rate but lower base versus lower tax rate and higher base. The absolute dollar is what counts.
Jonathan Duong 23:54
Yeah, exactly. Again, there’s no “one size fits all” to any of this.
Oftentimes, being a podcast listener myself, it’s an easy cop-out for the podcast interviewee to take. It’s like this is all facts and circumstances, but it really is. This stuff is very complicated in application, and it can be a highly different answer from one investor to the next.
Andrew Chen 24:18
In financial planning, do you have software that runs scenarios to try to optimize for the least number of lifetime tax dollars or sensitivities that you run? In practice, how do you actually execute this?
Jonathan Duong 24:34
It’s a combination of software, manual research and calculations in Excel, and so on. And then, in addition to that, just leveraging and thinking through, “What are the likely outcomes for this client?”
Are they somebody who is likely going to draw down the majority of their portfolio during retirement, and they’re not going to have a large estate at the end? Are they somebody who is thinking about they actually do want to likely provide some gifts, whether that’s charitable giving, or they may pass away and have a large taxable portfolio, they’re going to have a step up in basis, and that can lead you to a situation where stocks in taxable is still the best answer?
So, it’s all of those things. We have some pretty advanced tax planning software that we use that helps us to visualize where on the tax spectrum a client actually is.
Where are they on ordinary income rates? Are there any surcharges that are coming into play, whether it’s additional Medicare tax at 0.9%, net investment income tax at 3.8%? Where are they on the capital gains bracket?
And then we can run an infinite number of scenarios where we say, “Let’s set a capital gains budget this year of $100.” What does that do to the client’s situation? Where does that move them along the tax spectrum, and which marginal bracket are they going to end up in?
So, it’s absolutely software. It’s also a lot of just using Excel and Google Sheets to run calculations.
We’ve got a pretty detailed portfolio of accounting software as well that allows us to go through and accumulate and understand all the income that’s been earned this year from the portfolio. What do we still project for the remainder of the year?
And then we use all of that to help inform the decision, and then talk to the client with those implications and decide, “Is it capital gains? Is that our strategy?”
“Is it IRA contributions to reduce income this year? Are we thinking about doing Roth conversions?” There’s just so many different things that can take place, and we have to have all that information to make those decisions.
Andrew Chen 26:31
Incidentally, I know the software may be prosumer or specialized software, but for the geeks out there, what are some of the names of the software programs you use?
Jonathan Duong 26:41
We use a series of software packages.
For financial planning, we use eMoney. It’s one of probably three or four major platforms out there. That’s a big one.
We use a software by a company called Advyzon, another package from a company called Covisum, as well as utilizing all the tools and resources that are available from Vanguard, from Dimensional or DFA.
There’s a lot of things that we use that all fit together as part of this process that we go through with our clients.
Andrew Chen 27:14
What is the thing you use for the tax visualization that you were just talking about?
Jonathan Duong 27:18
It’s a software through a company called Covisum. They have a tax clarity software that we use.
It’s definitely an advisor software. To my knowledge, they don’t have any consumer-facing application.
Andrew Chen 27:29
All right. I’ll make sure I get the links from you later for that, so I can link to those in the show notes, just for those who are curious.
And then you also mentioned a moment ago that there might be some narrow circumstances where tax-exempt bonds like munis might actually make sense to hold in a tax-advantaged account. Could you say that again one more time what those circumstances might be?
Jonathan Duong 27:55
In most circumstances, in most situations throughout recent history, pandemics excluded, pre-2020, typically what you’re going to expect to see, if you compare the treasury yield curve versus a municipal yield curve, you have to take into account a couple of different things as an investor. And this is what I think the market does take into account.
Although municipal bonds are very high-quality, they’re not the same as treasury bonds. There is some credit risk from municipalities with municipal bonds.
At the same time, the tax benefit of not having to pay federal income tax on municipal bond interest, because that’s valuable, that’s also another component that’s typically taken into account when you compare the yields on, let’s say, a two-year term on the treasury yield curve versus a two-year term on the municipal yield curve. You’re going to see both of those things taken into account.
And typically, what that’s going to end up meaning, in most situations, is that you do need to still do a calculation, what we call a tax-equivalent yield, where you would take the treasury bond yield, you’d apply your federal tax rate to try to normalize the two, to compare them apples to apples.
So, you would say, “Yes, I’m not getting as good of a yield on my municipal bond, but given the fact that that is federally tax-free, I have to normalize it to compare it, to true it up to make it equal to my treasury yield.”
All of that to say, what we did see in Q1 of this year is that there was a big flight to safety. Everybody thought the pandemic is unprecedented. It was unprecedented in thinking the world is going to end, so there was a huge flight to safety.
And what that ultimately meant is that bonds with credit risk (corporate bonds, municipal bonds), their prices dropped dramatically. And so the yields surged because prices and yields go in opposite directions. So when prices dropped, say, 5%, 10%, 15%, depending on the particular bond asset class, the yields spiked.
So, when you had an opportunity for a municipal bond to get a yield of, say, 2-3%, that could be pretty lucrative. Even if you were abandoning the tax benefit, even if you were saying, “I’m going to hold this on my IRA or Roth IRA,” it still could have been more lucrative at that point in time than the other investment choices that are available to you.
Andrew Chen 30:31
But why would you hold that in a tax-advantaged account? Unless it’s not available to purchase in a taxable account, which I don’t know when that would be the case.
Jonathan Duong 30:45
For example, if you are like that investor we talked about at the beginning who is only investing in their 401(k).
Andrew Chen 30:52
I got you. But if you had a choice between the two, would there ever be a scenario where it would actually make more sense to hold the tax-exempt bond?
Jonathan Duong 31:02
It would be a situation where, depending on the amount of tax-advantaged space that you have, depending on the size of your portfolio, and how much bonds you actually need to hold, all else equal, you don’t want to waste any of your tax-advantaged space at all. So, in some cases, you’re saying, “In order to fulfill my asset allocation, I have to own this percentage of bonds.”
“And I don’t have enough money. I’m not going to take a distribution from my IRA and go put it in a taxable account. I would never do that.”
“So, in order to fulfill my asset allocation, I’ve got this pool of money in my IRA, and I have choices. I could invest in treasury bonds, corporate bonds, municipal bonds, international investment grade bonds. I could invest in any of these investment classes.”
And there was a period of time in Q1 where you could have absolutely made an argument that the best bond asset class to hold anywhere was municipals because of that high yield. So, it’s not that I’m preferring to necessarily hold it in one account versus another. It was just the best yield that was available at that particular point in time.
Andrew Chen 32:05
Got it. Cool. Let’s move on to REITs.
Where would you place these?
Jonathan Duong 32:12
As we’re getting into a lot of the less traditional (real estate is still fairly traditional, but less traditional) asset classes, and we move away from stocks and bonds, I think the overarching theme is generally going to be: they’re going to typically not be very tax-efficient.
There’s going to be a lot of ordinary income or a lot of other hoops you have to jump through as a taxpayer, as an investor, a lot of other gotchas that you really have to be careful of.
With REITs, in general, they’re going to be very tax-inefficient. The real estate investment structure, by definition, for real estate investment trusts, it requires that 90% plus of the income ends up getting distributed to investors. And that tends to be all ordinary income.
Now, under the Tax Cuts and Jobs Act a few years ago, you can, with a lot of REIT funds, take advantage of the QBI deduction. So that can be helpful.
But right now, that’s temporary. It’s not guaranteed to be an indefinite benefit. Right now, it would sunset about five or six years from now, so that’s not an indefinite benefit.
Second, just because of the taxation and the application of that, for most middle-income to high-income investors, and the tax complexity that goes along with it, even though that QBI deduction is helpful, I still don’t think that REITs really belong in a taxable account for most investors. I still think a tax-advantaged account is going to be preferable.
Although, in some cases, REIT income is not as punitive or as bad for low-income taxpayers, but in general, it’s going to be better in a tax-advantaged account.
Andrew Chen 33:57
What about physical real estate? Because you can actually hold this in a tax-advantaged account. As you know, you can have a self-directed solo 401(k) or a Roth 401(k) or IRA variety, or you could just purchase real estate in a fully taxable manner.
Jonathan Duong 34:12
This is an area that’s really littered with potential issues and trouble, so it’s not something that we spend a lot of time on. Oftentimes, one of the biggest concerns that comes up is, if they’re doing direct real estate investment, they’ll tend to buy things that they know or that they have a connection with. And that’s hugely problematic in an IRA.
You can’t have a benefit from that asset while also investing in it. That can be hugely problematic. You can’t go and put a vacation property in your IRA, and then you use it part time, and then you also treat it as an investment.
So, there’s a lot of problems that can exist with a direct real estate investment inside of an IRA, not to mention where do you actually custody this, and a lot of other issues that arise. So it’s not something we tend to really focus on terribly much.
But I think in general, if you look at direct real estate investments, oftentimes where investors are going to find the most value out of them is actually by owning direct real estate just inside of an LLC or an S corp or something like that, because you get to take advantage of depreciation, and because you get to take advantage of losses and be able to carry forward losses if you’re actively invested in the real estate, and so on.
Usually, for clients that we have where they own a real property asset, they’ve got rental income or something like that, they’re typically going to end up finding the most value to do that in their taxable account. So, on the IRA side, for direct investment, it’s just an area that investors have to be very careful of because it can lead to a lot of potential issues in terms of tax compliance if you’re not careful.