Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions


Asset Location

Taxation should be considered when deciding which assets to hold in which account, assuming you have multiple accounts. Suppose you want to invest some of your money in corporate bonds. You could hold small amounts of bonds or bond funds in each of your accounts, including taxable one(s). But in the near-term you’d be better off holding them in tax-deferred accounts, thereby avoiding relatively high marginal tax rates on the bond interest.

In contrast, Municipal bonds should arguably be placed in your taxable account. Municipal bonds are issued by state, city or county governments. The federal government doesn’t impose taxes on interest paid by municipalities. In some cases residents of a state are also exempt from paying state taxes on local state bonds. The higher a person’s marginal tax rate, the higher the benefit from receiving federal- or state-tax exempt interest payments. Since municipal bonds already have a significant amount of tax protection it would be redundant to place them in tax-deferred accounts.

Of course, the decision to invest in municipal bonds must also take into consideration the risks and returns one can expect, as well as any diversification potential across all other invested assets.  

There is a whole body of literature on the question of which accounts should hold which types of assets. The concept is known as Asset Location, i.e., where should certain assets be located. The basic intuition outlined above suggests that since bond interest is subject to marginal income tax rates, and doctors tend to be in higher marginal tax brackets (around 35%), their corporate bond holdings should be in tax-deferred accounts. In contrast, qualified dividends and long-term capital gains from stock investments are taxed at 15% (or 20% for the highest earners), making it wiser to hold them in taxable accounts. This assumes doctors max out their tax-deferred contributions annually and have some money left over which they put into taxable accounts. If you only have tax-deferred accounts the distinction is moot.

But like many things in finance, the basic intuition above can be overridden. Models that run nest-egg forecasts several decades into the future may show that in the long-run, it’s better to do the reverse, i.e., hold bonds in taxable accounts and stocks in tax-advantaged accounts. This stems mostly from the fact that the expected annual returns on stocks, at around 10%, are much higher than those on bonds, at around 2%. Taxes are applied to the growth on assets, not to the basis. This means that even though the tax rates on equities are relatively low, the absolute dollar size of gains on equities is high compared to the dollar gains on bonds. Equities realize much higher growth over extended periods than bonds, so the dollar amount of taxes is much higher on them. For this reason, placing stocks in tax-deferred accounts may make more sense over a very long-term.

Asset location is one of the proverbial rabbit holes in personal finance. It’s easy to chase intuition down one hole and get totally lost in all the arguments and counterarguments.

To keep things simple I offer two observations:

  1. Asset location should be a secondary consideration. Arguably the more important one is asset allocation. Your energy should be spent on the latter—not the former.
  2. All the convoluted arguments regarding asset location hinge on the relative magnitudes of future tax rates on bond vs. equity income. Currently, the highest marginal tax rates on ordinary income (which includes bond interest income) are much higher than those on equity income (dividends and capital gains). You could spend a lot of time creating an intricate asset location model only to see it all wasted when tax rates are changed in 4, or 8, or 12 years.

The second point raises a legitimate question: How likely is it that tax rates will change dramatically? For an answer let’s turn to historical precedent. Since 1978, the top federal personal tax rates have changed a dozen times. Over this period the top marginal tax rate on interest and dividend income has been as high as 70%. Current rates are among the lowest we’ve experienced during the last four decades. From 1988-1990 the top rates on interest, dividend and capital gains were all the same at 28%.

Thus, the answer to the question is that it’s quite likely that rates will change again. This supports my observation that it’s not a good use of time to make intricate forecasts of future tax rates.

Since we don’t know what future tax legislation may be thrust upon us, there’s a basic tax diversification argument to be made for holding multiple account types with different tax benefits. Some may be hurt by future legislation, while others may benefit from it.

For more on income sources and taxation please see the tax section of e-Book 3: Investing Basics for Doctors. 


Saver's Credit

The IRS allows a tax credit for making eligible contributions to your IRA or employer-sponsored retirement plan. Per the IRS website, the eligibility requirements include:

  1. You're age 18 or older,
  2. You're not claimed as a dependent on another person’s return, and
  3. You're not a student.

You're a student if during any part of 5 calendar months of the tax year you were enrolled as a student on a full-time basis.

The credit is a percentage of contributions you make to eligible accounts (subject to income limits), including but not limited to: traditional or Roth IRA, elective salary deferral contributions to a 401(k), 403(b), governmental 457(b), SARSEP, or SIMPLE plan, voluntary after-tax employee contributions made to a qualified retirement plan (including the federal Thrift Savings Plan) or 403(b) plan.
There are various restrictions, most notably a fairly low income ceiling, per the table, below: 

2020 Saver's Credit

Credit Rate Married Filing Jointly  Head of Household   All Other Filers*
50% of your contribution   AGI not more than $39,000 AGI not more than $29,250  AGI not more than $19,500
20% of your contribution $39,001 - $42,500  $29,250 - $31,875  $19,501 - $21,250
10% of your contribution   $42,501 - $65,000   $31,876 - $48,750  $21,251 - $32,500
0% of your contribution more than $65,000 more than $48,750  more than $32,500

*Single, married filing separately, or qualifying widow(er)

A single resident earning $65,000 is likely to be ineligible for the credit.

For additional details visit the IRS site.   


Final Tax-Related Observations

Stating the obvious, minimizing one’s tax bill should be pursued legally. Avoiding taxes through legal means is perfectly legitimate. Evading taxes that should be paid is illegal.

Tax-related decisions should be undertaken with the advice of a competent CPA or tax attorney.


Related Links:

Nerdwallet Federal Income Tax Brackets

Nerdwallet Dividend Tax Rates

If you insist on going down the rabbit hole on asset location: