Location, Location, Location! How Asset Placement Can Save You Taxes

TaxesAsset Placement is a popular discussion among financial planners (we’re a nerdy bunch). Asset Placement is determining what type of account (IRA, Roth IRA, trust, etc.) should hold what type of investment (bonds, US stocks, foreign stocks, real estate, etc.). If you ignore asset placement and you are agnostic as to tax consequences, you are probably paying higher taxes than necessary.  Who likes unnecessary taxes?  No hands raised.

Asset Placement 101

The most basic discussion on asset placement says “bonds go into tax-deferred accounts like IRAs, and stocks go into taxable accounts.”  Capital gains and qualified dividends in an IRA are taxed at ordinary income rates when they are distributed.  Ordinary income tax rates for most taxpayers range from 25% and higher.  On the other hand, capital gains and qualified dividends—both of which come from stocks or stock-based mutual funds—in the taxable accounts pay taxes at the favorable capital gain tax rates of 0%, 15%, or 20%.  Bond interest is ordinary income and that’s the kind of income we want to defer (i.e., put that in your IRA).

Asset Placement 201

Let’s look at Foreign Stocks.  We invest in foreign stocks via two primary methods, either individual securities like Royal Dutch Shell or through mutual funds that invest in non-US companies. These are often classified as Foreign, Emerging Markets or Developed Markets funds.  Global funds fits into that, too, but these include both US and foreign stocks.  For the sake of this discussion, let’s keep US and Foreign in separate mutual funds.

When a Foreign Stock pays dividends, it is common for its country of incorporation to withhold taxes on the dividends.  After all, the company is sending income to a foreigner.  If Royal Dutch Shell is incorporated in the UK (although headquartered in the Netherlands), the UK wants to tax those earnings that are leaving their country.  So each of you that own foreign stocks—whether individually or through a mutual fund—may be paying taxes to a foreign government. Did you know you are entitled to receive a credit on your tax return for these foreign taxes paid? Yes! It’s true! However, the investment must be in an account that allows you to take the credit.

Let’s contrast US taxation in your individual investment account versus your IRA.

Individual Account (also applies to a joint or trust account)

You receive the foreign dividend.  On your annual 1099-DIV from Royal Dutch Shell, it tells you the dividends that you received (you pay tax on this income) and the foreign taxes withheld.  You are allowed a credit on your Form 1040 for those foreign taxes withheld.  In essence, for US purposes, those dividends become either tax-free or are taxed at a substantially lower rate and eliminates the double taxation. Hooray!

IRA Account

In the IRA, there is no credit for the foreign taxes withheld. The UK does not care if your Royal Dutch Shell stock is held in an IRA, a partnership, an LLC, or your safe deposit box.  They are going to withhold UK taxes on the distribution and the credit for foreign taxes paid is available only in the year the dividends are paid.  Later, when you take IRA withdrawals, the foreign dividends that you’ve earned are fully taxable at ordinary income tax rates and you do not get to claim your foreign tax credit. Boo! Hiss!

As you might guess, we strive to hold Foreign Stocks outside of our clients’ IRA and Roth IRA accounts and we recommend that you do the same.  Your portfolio will be a bit more tax-efficient by avoiding double taxation and your wallet will thank you come tax time!

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