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You are probably aware of the three most crucial aspects of real estate investing: location, location, location. This concept is also prevalent in portfolio management. In this article, I’ll discuss asset location; an investment strategy that could enhance your portfolio's after-tax returns and help preserve more of your wealth. We’ll cover how it works as well as key points and strategies to consider.
Asset Location Versus Asset Allocation
It’s important to differentiate asset location from asset allocation. Although they are related, they are two different portfolio management techniques.
Asset allocation involves dividing your investments between various asset classes, such as stocks, bonds, and real estate, to name a few. This allocation, or mix of investments, is how we achieve a balance between market returns and risk management.
Asset location involves deciding where to place your investments between your taxable, tax-deferred, and tax-free accounts in the most tax-efficient manner. The primary objective here is to maximize after-tax returns.
Let’s Talk Tax Efficiency
Different investments are subject to different tax rules. The same goes for account types. Before we can place investments into accounts in the most tax-efficient manner, we need to understand the tax nature of the investments and investment accounts we’re using.
The Tax-Efficiency of Investments
There is a hierarchy in the tax efficiency of investments. Bonds and real estate investment trusts (REITs) are generally on the lower end of this hierarchy. Taxable bonds generate interest income that is fully taxable as ordinary income, making them less tax-efficient. REITs also fall into this category as they tend to distribute a significant portion of their income as non-qualified dividends, which are taxed at ordinary income tax rates.
Stocks on the other hand are generally considered tax-efficient investments because they have the potential for lower tax rates on long-term capital gains and qualified dividends, which are often taxed at a lower rate than interest income.
Municipal bonds stand out as the most tax-efficient because their interest income is typically exempt from federal income taxes and often from state and local taxes as well (if the bond issuer is in the same state as you).
This is not an exhaustive list describing the hierarchy of tax-efficient investments, as we could drill down further into each category, but you get the idea.
The Tax-Efficiency of Accounts
Taxable accounts, such as traditional brokerage accounts, are considered the least tax-efficient. They are taxed when you earn dividends, interest, or realize any capital gains by selling investments that increased in value. These accounts are not tax-sheltered in any way.
Tax-deferred accounts include traditional 401(k)s, 403(b)s, IRAs, and annuities. Investments held in these accounts are not taxed in the year the income is earned or realized, but instead are taxed when the money is withdrawn. Any amounts withdrawn will be treated as ordinary income, but because you can defer taxes, they are more tax-efficient than taxable accounts.
Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s require contributions to be made with after-tax dollars. However, the tradeoff is money grows tax-free, meaning no taxes are paid when dividends, interest, or capital gains are incurred, and the money is withdrawn tax-free as long as you meet the requirements. It is a truly tax-free account.
I should mention that Health Savings Accounts (HSAs) have the same tax benefits as Roths if the proceeds are used for qualified medical expenses, but come with the added benefit of a tax deduction for contributions. Something the mighty Roth does not allow.
How Asset Location Works
The concept of asset location is simple: you place your least tax-efficient investments into your most tax-efficient accounts, and your most tax-efficient investments into your least tax-efficient accounts. By way of example, ideally, you want to place taxable bonds that generate ordinary income in a tax-deferred, or tax-sheltered, account like an IRA. Your tax-efficient investments, such as stocks or municipal bonds, would go into your taxable accounts where the tax efficiency of investments is more important.
Although the concept is simple, implementing this strategy is not as simple as it may seem due to limited space in your tax-exempt accounts. If there were no restrictions, you could shelter all your investments from income tax and be done with it. However, in reality, trade-offs must be made to ensure the best use of your tax-exempt "space."
Here’s an example. You have $1 million spread out between an IRA and a taxable account. Additionally, your desired asset allocation is 60% stocks and 40% bonds, which means you will have $600,000 allocated to stocks and $400,000 to bonds. However, your IRA has a value of $300,000, and your taxable account $700,000. Normally, you want to place your tax-inefficient investments (bonds) into your tax-efficient account (IRA), but there isn’t enough “room.”
In this case, you will have a $100,000 surplus ($400,000 minus $300,000) of bonds that must go into your taxable account. When space is limited, you want to do this in the most tax-efficient manner, which means you start by placing the investments that generate the most ordinary income in your IRA. When the IRA is full, further consideration comes into play. Based on your tax situation, you’ll have to decide if it makes sense to utilize fully taxable bonds, tax-advantaged bonds, or a combination of the two (you can read my article on maximizing the after-tax yield of bonds here). Lastly, your stock investments must be analyzed to ensure they are appropriate for your tax situation.
Planning Ahead
Many factors come into play when determining an asset allocation and asset location strategy. Here are some suggestions on how to do that.
Before deciding where to place your assets, determine your suitable asset allocation based on your individual goals and risk tolerance. Only then can you determine where to hold your assets for tax-efficiency.
Are you close to retirement or still have a long way to go? Do you want to leave an inheritance? Is your net worth expected to change in the next few years? These spending, estate planning, and other needs may override or influence your optimal asset location strategy.
What are your options for tax-exempt accounts, such as Roth IRAs, traditional IRAs, and company retirement plans? How much space do you have in each?
What is your current tax situation versus your future outlook? The higher your income, and therefore the higher your marginal tax rates, the more you benefit from asset location strategies. How will your income change in the future or retirement?
Consider the benefits of holding assets in taxable accounts, such as being able to utilize foreign tax credits from international investments, offsetting capital gains with capital losses, allowing your heirs to receive a step-up in basis upon inheritance, and/or donating highly appreciated shares to charity to reduce capital gains taxes.
How might changes in tax laws affect your plans?
Art and Science
There is an art and science to asset location that investors should be aware of. And, as I mentioned above, the concept is simple but implementation can be tricky. Here are some reasons why your asset location planning may fall short:
Lack of Organization - Over the years, families often accumulate a mix of accounts that might span several different financial institutions. As your assets grow, it becomes increasingly challenging to organize them into a cohesive plan.
Lack of expertise – Asset location strategies require knowledge regarding the tax status of investments and account types, not to mention skill in portfolio management, tax planning, and estate planning.
Lack of monitoring - Asset location is not a one-time task. As your goals, the market, and government regulations change, your assets need ongoing management to maintain their desired efficiencies.
Conclusion
Asset location is a powerful tool in the hands of savvy investors. By taking into account the tax implications of different types of accounts and placing investments strategically, you can potentially enhance your overall investment returns (and wealth) by minimizing your tax burden. However, if you have concerns that your investment accounts may not be structured in the most tax-efficient manner, or are not aligned with your goals, you should speak to a financial or tax professional who can help you make informed decisions.
Tad Jakes, CFP®, EA, ECA