Most investors do not pay nearly enough attention to the tax efficiency of their investment plans. This unnecessarily increases taxes paid and causes a significant tax-drag on investment portfolios. Minimizing taxes on investment assets can be effectively managed to produce greater after-tax wealth and increase the probability of achieving investment objectives. Asset location strategies are one of the key strategies to accomplish these objectives.
Table 1: Reasons to put tax-efficient equity funds in taxable accounts as opposed to tax-deferred accounts:
- Equities receive capital gains treatment; fixed-income is taxed at ordinary income
- Capital gains are only due when realized
- Tax losses can be harvested; the more volatile the asset, the more valuable the option to harvest losses
- Stepped-up cost basis upon death so capital gains do not have to be realized
- Ability to donate highly-appreciated shares to charity for income tax and estate tax planning
- Foreign tax credits received for international investments in taxable accounts only
Asset Allocation vs. Asset Location
Investors are commonly familiar with the concept of asset allocation, which is an investment strategy that utilizes diversification in an attempt to balance risk versus reward by combining asset classes within an investment portfolio. However, when investors have multiple types of accounts—tax-deferred, taxable, tax-free, or trust accounts for example—another choice on where to locate specific assets from the desired investment allocation must also be made. This is a choice that is often ignored or mismanaged.
Since taxable accounts generate 1099s each year and taxes are paid on dividends, interest, and capital gains, these accounts are very tax-inefficient compared to tax-deferred retirement accounts. Therefore, outside of a reasonable, liquid cash reserve, a preference should be shown to put tax-efficient equities into taxable accounts to minimize tax drag. (See Table 1.)
Asset location benefits will vary based on a multitude of factors and will differ for each investor. A 2005 study by Gobind Daryanani, Ph.D. quantified the potential benefits of an asset location strategy and showed that a reasonable expectation is an increase of 20 basis points (0.20%) each year to overall net investment returns but can be greater with increased time horizon, tax rates, and expected returns.
Applying Asset Location
The concept of asset location is relatively straight forward. However, the implementation and ongoing portfolio management, particularly in retirement, can quickly make things more complex. For example, assume the desired asset allocation is a 50% stock and 50% bond portfolio. Yet, the tax-deferred accounts comprise 70% of total assets. After placing the 50% of bonds into the tax-deferred account, what then?
When this occurs an investor needs to rank the tax efficiency of the investments contained in the allocation. A good rule of thumb is that large capitalization, growth-oriented assets should be placed first into taxable accounts. Growth assets generally pay less or no dividends, which produce tax consequences. Placed first into tax-deferred accounts should be tax-inefficient assets such as real estate investment trusts (REITs), commodities, and small capitalization stock funds where fund turnover tends to be higher than larger companies.
If the example is reversed and 70% of total assets are held in taxable accounts and the same asset allocation is desired, 30% of taxable bonds can be placed into tax-deferred accounts. Then the 20% balance of the bond allocation can be comprised of tax-free municipal bonds, utilized in taxable accounts.
Using taxable bonds in tax-deferred accounts is generally preferable to using tax-free municipal bonds in taxable accounts. Taxable bonds yield a higher interest rate than tax-free bonds. Additionally, tax-free interest is included in the calculations for taxation of Social Security and Medicare Part B premium cost.
Implications for Investors
The downside to utilizing asset location strategies is that doing so not only adds complexity to the portfolio management process and also enables behavioral bias in investors. When locating specific assets in various accounts, it is very likely that these accounts will perform quite differently at times. Since a fully diversified portfolio is not placed within each account, performance differences are magnified. This tunnel-vision like effect can cause investors to forget their overall diversification of their portfolio across all household accounts and can lead to imprudent decision making.
It is very important that investors know they must first focus on their asset allocation decision and then secondarily on their asset location decision. Following a sound asset location strategy can help investors increase their after-tax return. While these increases will be greater for those with greater time horizon, higher tax rates, and larger expected returns, in today’s low interest rate and equity return environment, every bit of increase to net investment returns helps.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.