Asset allocation is the process of placing certain amounts of your investment portfolio into various asset classes. It forces you to diversify and balances your portfolio with your needs and goals for risk and return. Asset LOcation, on the other hand, is a tax-focused strategy designed to reduce your overall tax obligations.
Asset LOcation is the process of determining which of your investment assets are highly tax-efficient and those which are horribly tax-inefficient. Once you determine your potential tax liability for each of your investments, you rank them from efficient to inefficient, then place them as best as possible in different accounts that are tax-free, tax-deferred, or taxable.
Asset LOcation is critically important to your overall investment plan for one reason . . . every tax dollar saved is a guaranteed return on your investment! If you pay less in taxes, it directly affects your bottom line!
Here’s what asset LOcation is and how it works.
Investment securities have different tax consequences
If your investment portfolio is truly diversified you’ll have several different asset classes . . . stocks, bonds, real estate, and commodities for example. You’ll also have subsets of those asset classes like foreign stocks (part of the stock allocation) or high yield bonds (part of the fixed income allocation).
Those securities may pay dividends, interest payments, and hopefully capital gains. Some yield more than others, and some deliver higher capital gains than others. These factors directly impact your tax consequences.
Because your investments have very different tax implications, where you LOCATE your investment assets between various types of taxable, pre-tax, and tax-free accounts has a big impact on your tax bill. Those tax implications only compound as the years go by.
Stocks are highly tax-efficient with their generally low dividend yield and deferred capital gains. Those gains for most investors are long-term in nature, and the dividends are predominantly “qualified” dividends which are taxed as long-term capital gains.
But not all investments are highly tax efficient!
Corporate bonds are not very tax-efficient at all! They have little to no capital gain potential and distribute regular interest income taxed at less-favorable ordinary income tax rates. Treasury bonds are no different except they’re slightly more tax-efficient simply because they pay less in income.
Investment management styles also have varying tax consequences
The way in which your investments are managed can be more or less tax-efficient as well. If your investment is mirroring an index, for example, it’s going to be more tax-efficient because the turnover (the velocity of trading inside the vehicle) is much lower. Lower turnover means lower tax implications because there are fewer trades to trigger gains and losses.
If your investments are actively trading securities they’ll be less tax-efficient. There are more trades to generate gains and losses in actively managed portfolios. For example, stock index funds will be more tax-efficient than actively managed stock mutual funds.
ETF’s and index funds are typically highly tax-efficient. Owning large-cap stocks in an ETF or index fund versus an actively managed mutual fund will always be more tax-efficient.
Keep the management “style” in mind as you create your asset LOcation plan. Every little bit of tax minimization helps!
Investment accounts have various tax consequences
The accounts you have to invest in also have different tax consequences. For example, your Roth IRAs and Roth 401(k)’s are tax-free forever! Your pre-tax IRAs and 401(k)’s are going to be taxed at ordinary income rates when you distribute funds. Any insurance-based investments you have may be withdrawn tax tax-free as a return of principal or even partially taxable and pro-rated over time. Finally, your taxable accounts will trigger a 1099 forcing you to pay tax every year.
Asset LOcation can get highly complex if you’re blending individual securities with mutual funds or ETF’s which may be active or passively managed. My goal is to explain the concept of asset LOcation, so for simplicities’ sake, I’ll base this article on index mutual funds or ETF’s that mimic the major asset classes.
Tax-efficiency of various asset classes
As you now know, there are several tax issues to deal with when you’re practicing asset LOcation. Your investments have tax implications, your investment management styles have tax implications, and your investment accounts have tax implications.
Let’s go a bit deeper into the tax implications of the types of investments you’ll own. Here’s a list of the major asset classes and some ETF’s I’ve chosen mainly from Vanguard to illustrate their tax-efficiency.
As you can see there’s a wide disparity between tax-efficient investments and tax-inefficient investments. That’s the beauty of asset LOcation! You get to take advantage of the tax implications of your investments and the accounts you hold them in!
You certainly wouldn’t want to put the high tax-implication real estate ETF in a taxable account if you can put it in an IRA or 401(k) right? And you wouldn’t want to put your emerging market funds in an IRA or 401(k) when they’re better off in a taxable account because they’re highly tax-efficient!
There’s the beauty of asset LOcation! You can micromanage your tax implications saving you massive amounts of tax dollars and it doesn’t require any additional investment risk!
How asset LOcation works and how you can use it
Generally speaking, your Roth IRA or Roth 401(k) will take priority in this process. For most people, putting the highest potential return asset class in the Roth first (regardless of tax implications) makes the most sense since those accounts will be tax-free forever! That’s where we want MASSIVE growth since we’ll never pay tax on that money!
This doesn’t always hold true for retirees who may use their Roth IRA for income in the near future. By the “near future” I mean anytime within the next 5 years. You want less volatility in the accounts you may be liquidating for retirement income. No one wants to be selling securities when they’re depressed due to a bad market cycle.
If you plan on withdrawing and spending some of your Roth IRA monies for any reason, you may want to adjust this strategy to have a more balanced approach in your Roth. Also, keep in mind minimizing your taxes with a brilliant retirement income and spending strategy is absolutely critical to squeezing every last dime from your retirement, and that may force you to distribute smaller bits and pieces of your Roth IRA’s over your lifetime to avoid pushing into higher income tax brackets.
Everyone is unique, however, and you’ll need to make this decision based on your financial and retirement plan. For now, I’m assuming you’re like most investors and you’re deferring Roth IRA distributions as long as it’s prudently possible so you want the maximum growth possible in the Roth IRA.
US and foreign stocks have the highest long-term potential for growth so we tend to put US stocks in the Roth IRA’s first, followed by other equity asset classes and possibly even real estate through REITs.
Why don’t we put international and/or emerging markets in the Roth IRA first? They’re substantially more volatile than US stocks. While they may have a slightly higher long term projection for growth, we’ll dial in the risk and keep our Roth invested in the US. There’s no perfect answer here, however. You can easily put your international and emerging markets in your Roth, I just personally prefer to keep that critically important account invested here at home versus overseas.
So we asset LOcate to the Roth IRA first. After that’s full we LOcate to the taxable accounts with assets that are highly tax-efficient. Finally, we backfill in the pre-tax accounts like your IRA or 401(k) with everything that’s left in your asset allocation. You’ll still have the same asset allocation, but your tax bill will be lower due to your LOcation strategy.
REMEMBER: Your overall asset allocation is MOST IMPORTANT! Do NOT change or tweak your asset allocation just for tax purposes. Going with a more risky (or less risky) portfolio for the sake of tax savings is a horrible mistake!
Getting the most benefit from asset LOcation
While asset LOcation in concept is fantastic, not everyone can take full advantage of it as a strategy. You’ll get the biggest benefit from asset LOcation if:
- Your various accounts (taxable, tax-free, and pre-tax) are close to equal in size or at least substantial in size, and
- Your asset allocation is relatively balanced (100% stock or 100% bond won’t work because there’s little to LOcate), and
- You’re in a high(er) tax bracket.
If you’re an all-stock or all bond investor with only one type of account the value is 0% because there’s no real asset LOcation that can be incorporated into your investment plan. If however you’ve got multiple account types (Roth, IRA, taxable) and your asset allocation isn’t heavily conservative or heavily risky, you should be able to enjoy a lot of the benefits asset LOcation provides (unless you’re not paying taxes anyway)!
Note: The Vanguard study doesn’t specifically reference tax-free accounts such as the Roth IRA. I added that into the discussion as I’m positive it has a big impact in addition to the pre-tax and taxable accounts.
Asset LOcation in summary
Put simply, asset LOcation will reduce the taxes you owe each year. Even saving small amounts of tax yearly will add up to substantial amounts of money during your retirement. The best part is those tax dollars saved will compound over time (but you won’t know it because you didn’t pay them!)
Your first goal is to make sure your asset allocation plan is dialed in for your needs and goals. Once that’s done, you can determine which accounts should hold your various asset classes to reduce your overall tax implications. Don’t forget, each time you rebalance your portfolio you’ll need to take your asset LOcation into consideration.
Asset LOcation is a highly valuable strategy and it doesn’t require any additional risk to take advantage of. Give asset LOcation a try with your portfolio . . . I’m sure you’ll enjoy the benefits over time!
Asset LOcation Frequently Asked Questions
Asset LOcation is the process of placing your highest potential growth assets in your tax-free accounts followed by your highly tax-efficient assets in your taxable accounts, and finally everything else in your pre-tax accounts like IRA’s or 401(k)’s. The purpose is to locate your investments wisely in order to reduce your overall tax implications.
After taking inventory of your investment accounts and the actual investments themselves, rank your investments from most tax-efficient to least tax-efficient. Start locating investments in your Roth IRA or Roth 401(k) first putting your maximum growth investments In these tax-free accounts (assuming you won’t be drawing from your Roth soon). Next put what’s left of your most tax-efficient investments in your taxable accounts which will reduce your 1099 income each year. Finally, put your least tax-efficient investments in your pre-tax IRA or 401(k).
Anyone with more than one type of investment account (Roth, IRA, taxable, etc.) and a balanced asset allocation plan who pays taxes can benefit from asset LOcation. Asset LOcation is a tax-minimization strategy, so the higher the tax bracket you’re in the more you’ll benefit from asset LOcation. You also need a diversified investment plan because there’s little LOcation that can be done if you’re all stock or all bonds. Finally, you need investment accounts with varying tax consequences to LOcate your investment assets to.