The Best Way to Minimize Taxes With Asset Location

Did you mean to say asset allocation? That’s usually the response we get from clients when we bring up asset location within their portfolio. Both asset allocation and asset location are important considerations when building an investment portfolio to meet a client’s specific goals. The best way to think about this is that asset allocation is what investments are in the portfolio and asset location is where those assets are located.

Most clients concentrate on asset allocation, or how much they will hold in stocks, bonds, hard assets or alternative assets. It’s one of the first discussions we have with a client as we dive into their risk tolerance and expected cash needs and retirement goals, and it’s certainly the most important decision.

But we go the next step for our clients by taking into consideration where those assets should be held within their portfolio. Why? Two important reasons. Asset location may potentially:

1. increase portfolio return, and
2. reduce taxes

Benefits of Asset Location

Since most client portfolios include several different types of accounts like joint accounts, 401ks, IRA rollovers, and Roth IRAs; asset location considers where and how investments are populated throughout these accounts. The goals, tax benefits, and investment options are all different for these account types, and it’s important to consider that when deciding which account should hold what assets.

Asset location is also client specific, and the goals will vary depending on their age and time horizon. To understand this better, let’s look at a few examples and take the easier (and more conventional) situation first:

Example Situation #1: Married couple, both age 40, 3 kids under 10 years of age, ok with moderate/aggressive risk

Let’s assume that this couple’s portfolio includes taxable accounts, they both have 401ks with their current employers, and they have two IRA accounts.

Their retirement accounts (401ks and IRAs) would be invested more aggressively because they have a longer time horizon than the taxable accounts.

From there, we look at the investment selections within their 401k and IRA accounts. It’s likely that the 401k accounts have limited investment options, so we take the best, lowest cost options available there. IRAs offered by custodians like Charles Schwab, Fidelity or Vanguard typically have unlimited investment options that may include more complex investments typically not offered by a 401k. We will use the more generous investment selections within the IRA to manage around the more limited options in the 401k. This provides diversification and reduces duplication within the various accounts.

For this family, it’s likely that some big ticket expenses like funding private school education, college expenses, or purchasing a house are on the horizon, so it would not make sense to take unnecessary risk in their taxable accounts.

The asset location example above is more conventional: risky assets in the retirement accounts and conservative investments in the taxable accounts.

Now let’s look at a situation we frequently see at Glassman Wealth Services:

Example Situation #2: Married couple, both age 62, 2 independent children, ok with moderate risk

Many of our clients are near retirement when they join us, and they want their portfolio to cover their retirement needs over the next 20-30 years. At this point, we look at all of their accounts as one large portfolio with moderate risk.

Our goal is to create the highest after-tax return on the portfolio while taking into consideration any expected cash needs from the portfolio.

We evaluate every investment we’re adding to the portfolio based on the following criteria:

1. expected return over the next 3-5 years
2. historical tax efficiency (i.e. how much taxable income or capital gains did the investments distribute)
3. anticipated capital gain distributions in the next 12 months

We populate the retirement accounts with the higher growth, tax-inefficient investments. We also prefer to add high yield bonds to the retirement accounts as well. While yields can vary greatly, these funds are currently yielding ~6% of ordinary income, so locating these types of investments in their retirement accounts may greatly reduce their tax bill. Other income generating investments like REITs (Real Estate Investment Trusts) and MLPs (Master Limited Partnerships) are other examples of investments to locate in IRAs.

The taxable accounts will be populated with a combination of municipal bonds, conservative investments, or investments that don’t generate a lot of taxable income.

The result of our asset location efforts is a portfolio designed to provide our clients with the proper risk allocation in the most tax-efficient manner.

Roth IRA and Asset Location

A Roth IRA plays a special role within a portfolio because the assets grow tax-free with after-tax dollars. These will likely be the last dollars that we recommend our clients tap, so this allows us to take some additional risk in the portfolio due to the extended time horizon. We include the Roth IRA in the total portfolio, but we use asset location to populate these accounts with more aggressive stock funds.

Enhancing After-Tax Returns with Asset Location

A lot of individuals and some advisors choose to look at each account separately, or they just fill the retirement accounts with their more aggressive assets. We think this is a lost opportunity. Instead, take the time to look at your accounts collectively, and use asset location to enhance the after-tax return of your investment portfolio.

Does your financial advisor consider asset location when creating your investment strategy? How important do you think asset location is to your investment goals?