Asset Location—What is it and why is it important?
/As we frequently discuss with our clients, asset allocation is by far the most important determinant of long-term investment portfolio performance. Asset allocation is the process of investing one’s investment dollars across various asset classes, regardless of the type of account where those assets are held.
The asset allocation for any investor determines what assets to own and in what proportions, and incorporates one’s individual goals, risk tolerance, and investment time horizon. The goal from asset allocation is to create a portfolio that has the potential to provide the highest long-term return for a given level of risk.
Perhaps less understood by investors is the impact of asset location within one’s overall asset mix. Asset location is the process of dividing different kinds of assets (stocks/stock funds, bonds/bond funds alternative investments, etc.) between both tax-advantaged retirement accounts (Roth IRA, Traditional IRA, 401(k), 403(b), etc.) and taxable accounts (individual, joint, revocable trusts, etc.) in order to enhance the long-term after-tax return for the investor.
The basic rule of thumb for an asset location strategy is that you want to hold as many of your tax-inefficient assets (i.e. those producing a higher level of taxable income) in your tax-advantaged account(s), and hold your tax-efficient assets (i.e. those that generate long-term capital gains) in your taxable account(s). All else being equal, the more tax-inefficient an investment is, the more tax you will pay on it every year if it is held in a taxable account.
Before one can formulate an asset location strategy though, it is important to have an understanding of one’s personal income tax situation (Keep in mind that the content within this white paper is intended to provide food for thought regarding the placement of assets in different types of accounts, rather than providing any specific income tax advice).
We can make some assumptions based on what we know for the next several years now that the personal marginal income tax brackets have been set through 2025 from the 2018 Tax Cuts and Jobs Act. Based on one’s taxable income level, those marginal income tax brackets range from 10% to 37%. Along with the setting of marginal income tax bracket levels, there were also some slight changes to how long-term capital gains tax rates apply (i.e. for most assets sold in a given tax year that are held for more than one year).
As illustrated in the attached chart (right), the long-term capital gains tax rates for 2018 (Married Filing Jointly) are either 0%, 15% or 20%. These rules are also set through 2025 (Note: Similar to the marginal income tax brackets, the capital gains tax rules would need Congress approval to be extended past 2025.)
Holding certain assets over others within taxable accounts has advantages that include the following -
As noted above, long-term capital gains producing assets are taxed at lower rates (0%, 15% or 20%) than assets producing other types of income in taxable accounts (10%-37%).
When filing one’s income taxes, realized capital losses from the sale of investments within taxable accounts can help reduce the investor’s Federal income tax liability.
Income taxes from capital gains can be entirely avoided when appreciated investments are held at death due to the stepped-up cost basis rules that exist.
Charitable gift planning (i.e. donating an appreciated asset such as stock to a charity) from a taxable account can produce greater tax savings for the donor compared to cash contributions.
Along with the above, asset location is potentially more beneficial for those investors in one of the higher income tax brackets.
Generally, if you are in one of the highest Federal income tax brackets (32%, 35%, or 37%), it might be wise to consider including some Federal Tax-exempt Municipal bonds/funds within your fixed income allocation. It is possible that the tax-exempt income generated from the Municipal bonds will leave more cash in your pocket than a similarly-rated taxable bond (after the taxes are paid on the taxable income that is generated).
Also, if you live in an area with high state or local income taxes (or both), it might make sense to own U.S. Treasury securities within your overall asset allocation strategy. Interest earned on U.S. Treasury securities, including treasury bills and bonds, is exempt from taxation at the state and local level, unlike that of most other types of taxable fixed income investments (i.e. corporate bonds).
For those in a higher income tax-bracket, income tax savings can typically occur by holding tax-efficient growth-oriented investments such as equity Exchange Traded Funds (ETFs) and stocks that focus on capital appreciation (and less on dividends) in a taxable account. These types of growth investments are likely subject to lower income taxes when compared to most actively managed mutual funds, where the investor has no control over the amount of capital gains distributions generated by the fund from year to year.
Taxable income-producing assets are generally best placed in a tax-advantaged account such as an IRA or 401(k), where the income tax liability can be deferred until a future date (i.e. taxed to the investor when distributions are mandatory at the age of 70 ½ at a time when the investor may be in a lower income tax bracket).
Keep in mind that the rules mentioned above are not set in stone. It will vary depending on one’s situation. For example, a sharp drop in the investor’s income within a short time period (i.e. due to transitioning from full employment to retirement, placing the investor in a different tax situation), or a move from a high income tax state to one with low or no state income tax, may mitigate the positive impact from an asset location strategy.
What kind of assets are considered tax-inefficient compared to tax-efficient?
Bonds, with the exception of tax-free municipal bonds and US Saving Bonds, are generally highly tax-inefficient, because they generate interest payments that are taxed at ordinary income rates. Potentially higher returning types of fixed income investments, such as U.S. High Yield and Emerging Markets Bonds, are some of the most tax-inefficient.
Real estate investment trusts (REITs) are also rated low on the tax-efficiency scale. The reason for this is that REITs are required by law to pay out at least 90% of their taxable income to their investors. Unlike other types of equities, income generated from REITs is typically taxed at higher ordinary income tax rates (rather than at the investor’s capital gains tax rate).
Individual stocks are, as a general rule, relatively tax-efficient if held for at least a year. This is because capital gains on the sale of stocks held for more than a year are currently taxed at a top federal rate of 23.8% (this includes the top long-term capital gain rate of 20% plus the 3.8% Medicare surtax on net investment income). Investors with lower taxable income would pay rates of 18.8%, 15%, or even 0% in some cases. Equity-based exchange-traded funds (ETFs) are taxed similar to stocks in most cases.
Stock mutual funds are more complex. While stock index funds and index ETFs are generally quite tax-efficient, many actively managed stock funds are tax-inefficient because of their high turnover rates. They sometimes distribute short-term capital gains, which are taxed at the higher ordinary income tax rates. Although it is difficult to make generalizations about which actively managed funds are more or less tax-efficient, large-cap funds have historically tended to be more tax-efficient on average than otherwise similar small-cap ones. Also, be aware that some equity funds are specifically-managed for tax efficiency, and they tend to be highly tax-efficient despite being actively managed.
Which investments should you place in certain types of accounts in order to potentially enhance long-term after-tax returns?
Before answering this, it must be pointed out that an asset location strategy is best utilized if the investor has both tax advantaged and taxable investment accounts. Assuming that the investor has a well-diversified investment portfolio across those accounts, including assets in the previously mentioned categories, placing as many of the most tax-efficient investments in the taxable account(s) and the least tax-efficient in the tax-advantaged retirement accounts will generally provide the greatest benefit. It is also very important that the overall portfolio diversification and its risk-reducing benefits is not compromised through the asset location process (i.e. in some instances, it might make sense to own a tax-inefficient asset(s) in a taxable account).
The following table provides a breakdown of some of the types of assets which are best and least suited for various types of accounts (A tax-deferred account would include a Traditional IRA or 401(k). A tax-exempt account would include a Roth IRA).
Due to the uniqueness of every investor’s situation though, it may happen that locating assets in specific accounts is not possible. Possible reasons for this would include –
The lack of flexibility the investor has in shifting assets across different types of accounts.
Poor investment choices available to the investor (i.e. lack of fund choices within a 401(k) plan).
A specific purpose for a certain type of investment/savings account (i.e. an account earmarked for long-term charitable gifting purposes or college saving for a grandchild).
In other words, there are many factors to consider before adhering to the standard asset location rule of thumb, which would place stocks and growth-oriented assets in taxable accounts and taxable bonds and taxable income-producing assets in tax-advantaged accounts. Despite this, asset location is still something that investors should consider when constructing an optimal investment portfolio, even without knowing how changes in the tax code might affect after-tax returns for the investor well into the future.
