Your e-mail has been sent.

In real estate, it’s location, location, location that often counts most. And in investing, the same bit of wisdom also has a place. Where you put your investments—meaning the type of account you choose—can make a major difference in how much you can earn, after tax, over time.

Should you use your brokerage account for the REIT fund you are investing in, or would it be better in your tax-deferred annuity? What about the growth stocks you have been eyeing or the municipal bonds you are laddering toward retirement income—should those go into a Roth or into your taxable account?

You can’t control market returns, and you can’t control tax law, but you can control how you use accounts that offer tax advantages—and good decisions about their use can add significantly to your bottom line, says Matthew Kenigsberg, vice president in Fidelity Strategic Advisers. This type of strategy is often referred to as active asset location.

How an active asset location strategy works

Let’s look at a hypothetical example (illustrated below). Say Adrian is thinking about investing $250,000 in a taxable bond fund for 20 years. For this example, we will assume Adrian pays a 36.8%* marginal income tax rate 1 and earns a 6% rate of return each year—before taxes. (Actual rates of return may be lower.) But which account will he hold the investment in? The answer matters. If he chooses a tax-deferred IRA, his liquidation value—the amount remaining after selling all assets and paying all taxes—could be nearly $75,000 greater than in a taxable account. If he chooses a tax-deferred variable annuity, his liquidation value might be nearly $50,000 more than in a taxable account.

Asset location has the potential to impact after-tax performance

This hypothetical example is not intended to predict or project investment results. Your actual results may be higher or lower than those shown here.

Assumptions include:

$250,000 investment, 20-year time horizon, 0.25% annual annuity charge for the tax-deferred variable annuity (VA), marginal federal income tax rate of 36.8% (33% ordinary income tax plus 3.8% Medicare surtax) for the entire period, and a 6% annual rate of return (equivalent to a 5.74% net annual rate of return for the VA) with the gain assumed to derive entirely from income (characterized for tax purposes as ordinary income). Investments that have the potential for a 6% annual rate of return also come with the risk of loss. This rate of return is not guaranteed.

In the taxable account, it is assumed that taxes incurred on the income are paid annually from the income itself, with the remainder reinvested. In the tax-deferred account, it is assumed that all income is reinvested. For the VA, it is assumed that all income—less the 0.25% annual annuity charge—is reinvested. It is assumed that the investor liquidates the VA and the tax-deferred account at the end of the time period, and pays taxes on the gains out of the proceeds. If the assets in these accounts were liquidated entirely in one year, the proceeds might increase the tax bracket to the marginal federal income tax rate of 43.4% (39.6% ordinary income tax plus 3.8% Medicare surtax), which would minimize and potentially eliminate any savings. To avoid this, the VA and tax-deferred account would need to be liquidated over the course of several years or annuitized, which would lengthen the deferral period.

State and local taxes, inflation, and fund and transaction fees were not taken into account in this example; if they had been, performance for the taxable account, the variable annuity, and the tax-deferred account would be lower. This example also does not take into account capital loss carry-forwards or other tax strategies that could be used to reduce taxes that could be incurred in a taxable account; to the extent these strategies apply to your situation, the comparative advantage of the variable annuity and tax-deferred account would be diminished. Lower tax rates on interest income would make the taxable investment more favorable. Changes in tax rates and tax treatment of investment earnings may impact the comparative results. Consider your current and anticipated investment horizon and income tax bracket when making an investment decision, as the illustration may not reflect these factors.

Ordinary income tax rates will apply to taxable amounts withdrawn from a tax-deferred investment.

The year-by-year account value for the taxable account shown above is: $259,480 for year 1, $269,319 for year 2, $279,532 for year 3, $290,132 for year 4, $301,134 for year 5, $312,553 for year 6, $324,405 for year 7, $336,706 for year 8, $349,474 for year 9, $362,726 for year 10, $376,481 for year 11, $390,757 for year 12, $405,574 for year 13, $420,954 for year 14, $436,916 for year 15, $453,484 for year 16, $470,680 for year 17, $488,528 for year 18, $507,053 for year 19, and $526,281 in year 20. The year-by-year value after federal income taxes have been deducted for the VA with 6% return less the 0.25% annual annuity charge shown above is: $259,061 for year 1, $268,642 for year 2, $278,773 for year 3, $289,484 for year 4, $300,810 for year 5, $312,785 for year 6, $325,447 for year 7, $338,835 for year 8, $352,991 for year 9, $367,959 for year 10, $383,785 for year 11, $400,519 for year 12, $418,213 for year 13, $436,921 for year 14, $456,702 for year 15, $477,618 for year 16, $499,733 for year 17, $523,117 for year 18, $547,841 for year 19, and $573,984 in year 20. The year-by-year value for the VA at a 0% annual return less the 0.25% annual annuity charge is: $249,375 for year 1, $248,752 for year 2, $248,130 for year 3, $247,509 for year 4, $246,891 for year 5, $246,273 for year 6, $245,658 for year 7, $245,044 for year 8, $244,431 for year 9, $243,820 for year 10, $243,210 for year 11, $242,602 for year 12, $241,996 for year 13, $241,391 for year 14, $240,787 for year 15, $240,185 for year 16, $239,585 for year 17, $238,986 for year 18, $238,388 for year 19, $237,792 for year 20.

Withdrawals of taxable amounts from tax-deferred IRAs and annuities are subject to ordinary income tax rates, and, if taken before age 59½, may be subject to a 10% IRS penalty.

VAs are generally not suitable for investors with a time horizons of less than 10 years, as in most cases there is little to no advantage over a taxable account for the first 10 years of the investment.

As you can see, tax deferral has the potential to make a big difference for investors—especially when matched with investments that may be subject to significant taxation. As illustrated in the hypothetical example above, qualified accounts such as IRAs, 401(k)s, 403(b)s or other workplace savings plans, may provide the greatest benefits in an asset location strategy. However, investors who have already maximized these options or who may not be eligible for them may want to consider deferred annuities, which charge additional fees and may be subject to different withdrawal rules, but can provide an additional option for tax-deferred saving.

Can you benefit from an active asset location strategy?

Many investors have several different types of accounts. Some are subject to taxes every year and others have tax advantages. Typically, restrictions on contributions or withdrawals prevent investors from simply saving everything in tax-advantaged accounts. So how do you decide what to put where?

There are four main criteria that tend to indicate whether an active asset location strategy would be a smart move for you. The more these criteria apply to your situation, the greater the potential advantage in after-tax returns.

• You pay a high marginal income tax rate: The higher the marginal income tax rate you pay, the bigger the potential benefits of active asset location. If you are in one of the highest three federal tax brackets, or if you live in a city or state with high income taxes, or both, a strategy to help make the location of your investments more tax efficient could be an easy way to boost your after-tax returns without assuming additional risk.
• You expect lower income taxes in retirement: If you plan to move to a state with much lower income taxes, or expect to be in a lower tax bracket due to reduced taxable income after you stop working, or both, an investment strategy designed to take advantage of additional tax deferral now can have a big impact later. This is because in addition to delaying taxation—which has significant benefits of its own—you will pay taxes at a lower rate in the future.
• You have a lot of tax-inefficient investments in taxable accounts: The more tax-inefficient assets you’re currently holding in taxable accounts (see below), the greater the potential to take advantage of active asset location.
• You expect to be invested for more than 10 years: Active asset location strategies generally take time to work (as a general rule, they require at least 10 years to be effective). The longer you can keep your assets invested, the greater the potential benefits from tax deferral. So if you are saving for retirement and expect to work at least another 10 years, or won’t need to use the money in your tax-advantaged accounts any sooner than that, an active tax location strategy could have a big impact. Note, however, that under some circumstances—such as a sharp drop in income or a move from a domicile with high state or local taxes to one with none—active asset location can have a significant impact in less than 10 years.

First, rate your investments on a tax-efficiency scale

If you are in position to take advantage of an active asset location strategy, you have to choose which assets to keep in your tax-advantaged accounts and which to leave in your taxable accounts.

All else being equal, the more tax inefficient an investment is, the more tax you pay on it. Below, we present ratings on a variety of investment types across a spectrum from very inefficient to very efficient. Of course, there is no way to know exactly what tax rates will apply to your investments in the future, but in general:

• Bonds with the exception of tax-free municipal bonds and U.S. Saving Bonds, are generally highly tax inefficient. Potentially higher returning, more volatile types of fixed income investments are the most tax inefficient.
• REITs are also rated low on the tax-efficiency scale. That’s because they are required by law to pay out at least 90% of their taxable income, and, unlike other equities, this income is generally taxed at higher ordinary income rates.
• Individual stocks are, as a general rule, relatively tax efficient. This is because qualified dividends and capital gains on the sale of stocks held a year or more are currently taxed at a top rate of 23.8% (this includes the top long-term capital gain rate of 20% plus the 3.8% Medicare surtax on net investment income). Less-affluent investors would pay rates of 18.8%, 15%, or even, in some cases, 0%. Equity-based exchange-traded funds (ETFs) are essentially taxed like stocks in most cases. However, note that of phaseouts on itemized deductions could, in an indirect way, drive the marginal tax rate you pay on stocks somewhat higher if you’re a high-income earner.

The story with stock mutual funds is more complex. While stock index funds are generally quite tax efficient, many actively managed stock funds are tax inefficient because of high turnover rates. They can distribute short-term capital gains, which are taxed at the higher ordinary income tax rates. Although it is difficult to make generalizations about which actively managed funds are more or less tax efficient, as you can see in the graph below, large-cap funds have historically tended to be more tax efficient on average than otherwise similar small-cap ones (recently, foreign value funds have been an exception to this rule).

Tax efficiency of stock mutual funds