By FPA member Jeanne Gibson Sullivan, CFP®

Last Updated: December 19, 2011

December is the time of year when the bulk of mutual fund distributions are paid out. You may not have made any changes to the mutual funds in your taxable account, but there may be short-term and/or long-term capital gains distributed which need to be reported on your tax return. So now is a good time of year to review your asset allocation, the tax efficiency of your assets and decide if assets in the proper type of account, which is called “asset location.” Below are some general comments on asset location. The specifics may vary depending on individual circumstances.

First, review your assets held in taxable accounts for tax efficiency. This refers to the amount paid out each year in distributions and how it is classified – dividends (qualified or non-qualified), short-term capital gains, long-term capital gains or anything else. There are different tax treatments for each, for example, long-term capital gains are taxed at a lower income rate than short-term capital gains. Your 1099 from your mutual funds held in a taxable account last year will tell you how much was paid and how it was classified. This is a good starting point. The websites for many mutual funds will tell you anticipated 2011 payouts and the type. Your tax adviser can also help guide you. 

Second, use the end of year to review your overall asset allocation. What portion do you want in stocks and bonds, in other words, how aggressive do you want to be? Within stocks and bonds, refine your diversification.

Third, “locate” assets as follows, assuming that you have money in each of the following buckets:

• Retirement Accounts — IRA/401(k): Tax “inefficient” assets are ideal candidates to house in your qualified retirement plans. These assets may generate a lot of taxable income if they were held in a taxable account, but are sheltered from taxes in a retirement account.
• Taxable Accounts: Tax “efficient” assets are well suited for taxable accounts. The primary example of a tax “efficient” asset is a stock index mutual fund. There is usually small turnover in index funds each year, fewer stocks bought and sold, and many of the dividends paid out are preferential from a tax standpoint. For those of you in a high tax bracket, if you have bonds in a taxable account, consider tax-free bonds or bond funds. The interest from bonds issued in your home state are generally exempt from state and federal income tax. Income from U.S. Treasury bonds is taxable for federal income tax, but often exempt from state income tax. Income from municipal bonds issued in other states is often taxable in your home state, but exempt from federal tax. The taxation of each type of bond is an area to review with your tax adviser. As always, tax considerations need to be balanced with other goals.
• Roth IRA: For those who are eligible to contribute to a Roth IRA [or Roth 401(k)], taking advantage of Roth IRAs can be an excellent investing and tax strategy. Earnings in a Roth IRA are not only tax-deferred, but withdrawals are tax-free and not subject to Required Minimum Distribution rules for the original owner. Thus, it is often desirable for this bucket to grow as much as possible for as long as possible. If so, then the most aggressive investments you want included in your overall portfolio are best located in the Roths.  

The tax ramifications can be quite complicated. Please consult your tax adviser for specifics relating to your situation. 

FPA member Jeanne Gibson Sullivan, CFP®, is the principal of Financially in Tune in Wakefield, MA and Director of Consumer Awareness for the FPA of Massachusetts.