As you build an investment portfolio, you probably consider your asset allocation and how that relates to your risk tolerance. But don’t confuse asset allocation with asset location, a straightforward process that could minimise taxes.
It’s a simple yet powerful strategy you can easily incorporate into your investment planning.
What is asset location?
Different types of investments have different tax rates. For instance, income tax is deducted from cash savings before you receive the interest. In contrast, capital gains from selling shares are taxed at a lower rate. Asset location maximises your after-tax returns by putting the right assets in the right accounts.
For example, you could keep income-producing investments like bonds in tax-advantaged accounts such as ISAs and pensions. On the other hand, assets with higher capital gains potential, such as shares, can go into standard taxable accounts to benefit from lower capital gains tax rates.
Could it help me?
Let me explain this using an example. Sarah is a basic rate taxpayer, and she has £500,000 invested in an ISA and a non-ISA Investment Account, with the amount split equally between the two. Each account invests in a portfolio of 50% global equities and 50% global bonds. Assuming the income yield for global equities is 1.5% and for global bonds is 2.46%, we can reduce income taxes by over 50% if we hold more equities in the non-ISA investment account and more bonds in the ISA.
Now, let’s factor in capital growth. Assuming global equities increase in value (in addition to the yield) by 11.5% and bonds increase by 2.4%, holding more equities in the ISA, and more bonds in the non-ISA investment account can reduce overall taxes by over a third.
An effective asset location strategy may only increase your returns by a fraction. However, these percentages can compound over time, significantly increasing your overall wealth. In the example above, that increase would be nearly £14,000 over ten years.
So, should I do it?
One thing we should be clear about is that this is not a one-size-fits-all process. Altering one strategy can affect another, and it is vital to consider the broader effects of any action you take. An effective asset location strategy should be part of a robust investment strategy. For the investment strategy to be robust, it should form part of a broader, comprehensive financial plan.
