Asset Location: Maximizing Growth while Minimizing Taxes

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When building an investment portfolio, we often spend a lot of time on what specific asset classes will make up the “investment pie.” Determining the right mix of asset types, namely stocks and bonds, to help maximize profits while minimizing risk is what we refer to as Asset Allocation. The idea is to strike the right balance between more potentially volatile assets such as stocks and more stable ones, like bonds, depending on your investment time horizon, risk tolerance, and other factors. This concept of asset allocation and properly diversifying your portfolio is something that many investors are familiar with and have probably heard over and over in their investing lives. However, Asset Location (and not to be confused with Asset Allocation), is a relatively unknown concept for many. I find that this is the case with many of the new clients that I work with when I get the opportunity to discuss our firm’s investment philosophy and some of the portfolio management techniques we utilize.  

What is Asset Location?

Extensive research has shown that having a properly diversified portfolio through effective asset allocation can make up to 90% of the return of your portfolio. As such, there is a good reason to take the necessary time and due diligence in making the proper asset allocation decision (and you should). However, you may be able to go further and potentially add additional returns using asset location. Asset location is a tax minimization strategy that takes advantage of the fact that different types of investments get different tax treatments. Using this strategy, an investor determines which investments should be held in tax-deferred accounts and which investments should be held in taxable accounts in order to maximize after-tax returns. Used properly with asset allocation, asset location done properly may help an investor achieve not only an optimal portfolio but a tax-efficient portfolio as well. It should be noted that although asset location may help reduce your overall tax bill, it is not a replacement for asset allocation.

How Does Asset Location work?

In order for an investor to benefit from asset location, they must have investments in both taxable and tax-deferred accounts. Asset location also works best in a balanced portfolio (60% equities / 40% fixed income) and the more you are heavily invested in equity or fixed income, the less of an impact asset location will have on minimizing taxes. Under this strategy, tax-inefficient assets should be held in tax-advantaged/tax-deferred accounts while tax-efficient assets should be held in taxable accounts. In real estate, it’s location, location, location. The same bit of wisdom may apply in investing as well. And while you can’t control the market or tax laws, you can control what investments to put in certain tax-advantaged accounts. As an example, real estate investment trusts (REITs) are considered to be a tax-inefficient asset class as they are required by law to pay out at least 90% of their taxable income in the form of dividends. And unlike other equities, this income is generally taxed at higher ordinary income rates as opposed to the favorable capital gains rates. So REITs are rated low on the “tax-efficiency scale.” As such, REITs are suited to be held in tax-deferred accounts such as an IRA, 401(k), or 403(b).

Similarly, bonds are generally highly tax-inefficient (with the exception of tax-free municipal bonds) as they generate interest payments that are taxed at ordinary income rates as well. So most types of bonds are great candidates to be placed in a tax-deferred account. Actively managed funds, due to its tax-inefficient nature, should also be parked in tax-deferred accounts to shield you from capital gain distributions. Since actively managed funds try to beat an index, their managers may buy and sell investments more often causing high turnover. The more they trade, the more likely they will accumulate capital gains and the higher your potential tax liability once those gains are tallied at the end of the year.

On the flip side, exchange-traded funds (ETFs) are very tax-efficient as the great majority of them do not pay out capital gain distributions. As such, we hold ETFs in our client’s taxable accounts. Asset classes such as U.S. Large Cap equity and U.S. Small Cap equity are particularly good candidates for taxable accounts primarily due to the benefit of having the growth in equities taxed at preferential long-term capital gains rates instead of ordinary income. Roth accounts, IRA and 401(k) plan accounts funded with after-tax dollars, should hold the most aggressive, “growth-oriented” asset classes since Roth accounts are likely the last bucket of assets a family touches. Hence, Roth IRAs are excellent investment vehicles to pass on to your beneficiaries upon your death.

Here is an example of how asset location might look in action (from “Nerds Eye View” by Michael Kitces).

 Bonds held in taxable account and stocks in the IRA: Bonds grow at a 3.75% after-tax growth rate (5% gross returns less 25% taxation), for a total future after-tax value of $500,000 x 1.0375^30 = $1,508,736. Stocks grow at a gross return of 10% for 30 years, but are then fully taxable when withdrawn from the IRA (still assuming a 25% tax rate), resulting in a final after-tax value of ($500,000 x 1.10^30) x (1-0.25) = $6,543,526. Total after-tax wealth is $8,052,262.

Stocks held in taxable account and bonds in the IRA: Bonds grow at a 5% gross return, but then are fully taxable at the time of IRA withdrawal, for a future after-tax value of ($500,000 x 1.05^30) x (1-0.25) = $1,620,728. Stocks grow at a gross return of 10% for 30 years, and the growth is then taxable at a 15% long-term capital gains tax rate, resulting in a gross value of ($500,000 x 1.10^30) = $8,724,701, $a tax liability of ($8.724,701 – $500,000) x (0.15) = $1,233,705, and a final after-tax value of $8,724,701 – $1,233,705 = $7,490,996. Total after-tax wealth is $9,111,724.

In conclusion, though asset location is not as frequently talked about in the world of personal finance and financial planning, it is equally important to asset allocation. While you cannot control market returns and tax law, you can control how to use accounts that offer tax advantages which can add to the bottom line of your portfolio in the long run. It is good to keep in mind that asset allocation and asset location work best when employed together as the two strategies combined can help you create an investment portfolio that is both tax-efficient and well-balanced. Here at RTD, we add further value by diligently investing the necessary time and energy to employ both asset allocation and asset location to build our clients’ portfolio with taxes in mind.