Asset Location - An effective tax strategy
Asset allocation vs. asset location
You may be familiar with asset allocation, which is the process of diversifying your investments across various asset classes such as stocks, bonds, cash, and real estate. You may have also used a myriad of techniques to determine your allocation. For example, the 120 rule, which is 120 minus your age to determine your percentage allocation to stocks, a risk tolerance questionnaire, or simply guessed.
It’s not about what you own but where you own it
Asset location considers which accounts to place investments into to minimize taxes.
Think of it this way, you can give several plants the same sun and water (asset allocation), but a tiny seed can only grow into a majestic tree with the right soil (asset location).
The gardener (Financial Advisor) has the role of taking care of and understanding every unique plant's needs and creating the right prerequisites for development, without forgetting about the whole garden (your financial picture).
When considering which asset classes to place in which accounts, there are significant trade-offs to consider when making asset location decisions. Various asset classes and accounts have different tax characteristics.
Investors traditionally considered these tax implications:
Bonds were placed in tax-sheltered accounts, such as IRAs, as they were taxed at ordinary income rates. The reason for this is that more bond income (yields) compared to stock income (dividends) should be sheltered from taxes. Also, the tax rate on bond income (ordinary income) is higher than the tax rate on stock income (capital gains), so having bonds in non-taxable accounts would avoid these higher rates.
Equities were placed in taxable accounts, such as brokerage accounts, because if they were held for longer than one year, they would receive long term capital gains treatment. Most people would have a long-term capital gain rates of 15 or 20%, determined by their taxable income.
Investors and Financial Advisors would line up the location of assets with their tax respective tax treatment. This straightforward method simplifies the world we live in.
In financial planning, we don't look at a single time period and provide guidance on a buy and hold strategy as if nothing changes. Many people will hold investments for years, if not decades, and it is crucial to consider the compounding effects over time.
Expected return is what matters
Historically bonds were purchased for two key reasons, income generation, and diversification; the price of government bonds tended to gain during periods when other risk assets would decline. However, yields are at historic lows, and a sizable portion of government bond yields in negative territory, so there is less value from getting tax-deferred compounding growth inside a retirement account. There's not much point to compounding on low returns.
For equities, the power of compounding returns has a much higher impact.
The conversation with your advisor should be on where to place the stocks with the highest return to capture the maximum compounding effect.
Higher return stocks have a compounding effect and tax drag, reducing potential return due to taxes. The viewpoint of just locating stocks to brokerage accounts to get favorable long-term capital gains tax treatment does not always work so well.
If you hold stocks in a brokerage account long enough to get the tax treatment and have a lot of turnover in the account or receive income through dividends, the compounding value reduces. It may be wise to consider putting these stocks in a different account.
You may also use high turnover active or momentum strategies, which may be appealing for the returns but have tax implications. It may be beneficial for these types of holdings to put them in an IRA or employer retirement accounts. Frequently the focus is so much on the pre-tax return that maximizing after-tax return is not even considered.
What investments to put in what accounts?
Modern portfolio diversification does not just simplify assets into stocks and bonds but considers sub-categories of stocks, bonds and alternative investments.
A Financial Advisor can help you optimize your after-tax return and place your investments in the right accounts.
Why does your advisor need to have oversight of all your accounts?
To determine the optimal asset allocation and asset location of your investments, three aspects need to be considered:
1. Tax treatment of investments and accounts
2. Expected return of investments
3. Time horizon
An advisor can only truly understand the full picture by having a bird's eye view of the household's accounts, which can understandably get more complicated if you're married or have larger families. An investor with a portfolio allocation of 60% stocks and 40% bonds might hold investments in both taxable and tax-deferred accounts. The overall allocation across all accounts should reflect this allocation but each account does not need to have the same asset mix. Creating the same asset allocation across all accounts discounts the tax benefits of placing the assets into the most suitable accounts to maximize after-tax return.
Asset location can help you significantly increase your after-tax treatment without saving more, working longer, or investing in high-risk investments to 'beat the market.' It's important to remember that the market environment dictates the most suitable asset location strategy. The optimal solution is always relative to what your assets yield, the return assumptions, and dynamic tax characteristics. A Financial Advisor can be your guide in an ever-changing landscape. There is not a single right answer, and solutions will depend on your personal situation and circumstances. However, applying these principles will maximize your after-tax retirement income and minimize taxes. Who doesn't want that?
Adviso Wealth is dedicated to working with people just like you. We want to give you the clarity and confidence you need to achieve your personal and financial goals.
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