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 (not to be confused with Asset Allocation), is a relatively unknown concept for many.
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. However, you may be able to add additional return using asset location.
Asset location is a tax minimization strategy that takes advantage of the fact that different types of investments are taxed differently. 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. While asset allocation is focused on building an optimal portfolio, asset location is focused on building a tax-efficient portfolio, both of which are critical to investor success.
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). The more concentrated you are 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 best 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. So most types of bonds are great candidates to be placed in a tax-deferred account. Actively managed funds are also tax-inefficient; since they are trying to beat an index, their managers may buy and sell investments more often causing high turnover. Ideally, they should also be placed in tax-deferred accounts to shield you from capital gain distributions.
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 as the growth in equities is taxed at preferential long-term capital gains rates instead of ordinary income. Roth accounts are funded with after-tax dollars and therefore should hold the most aggressive, “growth-oriented” ETFs.
Although 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 changes, you can control how you invest within accounts that are taxed differently, to add to the bottom line of your portfolio. Asset allocation and asset location work best when combined. At RTD, we diligently make use of these two strategies to create investment portfolios that are both well-balanced and tax-efficient.