A cautionary tale: The importance of asset location, a hard lesson

Posted Jan 31 2008, 10:06 AM by Karen Datko 

Filed under: Investing, Retirement, Taxes, The Dough Roller

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This post comes from partner blog The Dough Roller.

Asset location involves dividing investments between taxable and tax-deferred accounts in the most tax-efficient manner. 

As a general rule, mutual funds that generate a lot of dividends or capital gains should be placed in 401(k), IRA or other retirement accounts. Investments that do not generate a lot of dividends or capital gains can be placed in taxable accounts. Following this strategy, I've put all my bond funds, REIT funds and most of my small cap funds in retirement accounts.

What happened to REIT mutual funds last year offers a hard lesson for some about why asset location is so important. 

2007 was not good for most REIT mutual funds. One of my REIT funds, Vanguard REIT Index (VGSIX), was down more than 16%. In the prior seven years, however, the fund did extremely well, as indicated in the box to the right.

So what's the problem? The problem is that when prices go down, fearful investors run. This year, outflows from REIT funds have accelerated, even though the losses this year have been rather modest, in my opinion. To pay these exiting shareholders, REIT mutual funds have had to sell shares. Many of these shares, bought years earlier, had substantial gains that have triggered significant capital gains for the shareholders who have stayed behind.

Fortunately for me, both of my REIT funds are in retirement accounts. For those holding REIT funds in taxable accounts, the capital gains hit this year could be substantial. USA Today reported, for example, that Davis Real Estate A (RPFRX) recently paid $8.45 per share in long-term capital gains. For a fund that is trading at about $30 per share, the distribution represents more than 20% of the fund's net asset value (NAV). For an investor who owned 1,000 shares, the 15% capital gains tax would hit them for more than $1,200.

The importance of asset location is not limited to capital gains. REIT funds must distribute 90% of their earnings each year in the form of dividends, which would generate taxable income if the fund were held in a taxable account. For this reason, I moved my Vanguard REIT Index fund into a rollover IRA several years ago.

If you invest in both taxable and retirement accounts, give a lot of thought to asset location. It could help you defer taxes on a substantial amount of capital gains and dividends.