Asset Location in an Investment Portfolio

Location, location, location—that’s what it’s all about in real estate, and in retail and other traffic-sensitive businesses. But how important is the location of assets within an investment …

Location, location, location—that’s what it’s all about in real estate, and in retail and other traffic-sensitive businesses. But how important is the location of assets within an investment portfolio?

For some investors, the question crops up each year when it’s time to rebalance a portfolio and/or invest newly saved funds. They want to know whether to make a new investment in a traditional retirement account, invest through a Roth account or hold it outside of tax-advantaged accounts altogether.

Some financial planners disagree on how important asset location is, and highly respected financial advisers have come to opposite conclusions about where certain asset classes should be placed. Many investment advisers don’t consider it at all, despite the potential effect on after-tax returns. So, here are a few ideas to get you started thinking about it.

Understanding the tax issue

The first thing to understand about asset location is that it’s a tax issue. If all accounts and all investment yields were taxed the same way, it wouldn’t make much difference where individual investments were held—indeed, there wouldn’t be as many choices.

Congress has used tax policy to encourage people to save and invest money and to plan for future needs, such as retirement, college tuition and medical care. As a result, under current U.S. tax law, long-term capital gains and dividends that meet certain requirements (known as “qualified dividends”) are taxed at 15 percent for taxpayers above the lowest tax bracket, and most other investment income (nonqualified dividends, interest and short-term gains) is taxed at marginal rates of up to 38 percent. Complicating matters further, some investment income, such as interest on municipal bonds, has no federal tax at all.

Not only are different kinds of income taxed at different rates, but also income on investments held in certain kinds of accounts is taxed at different times. Tax-deferred accounts were created to encourage people to save money they expect to use for specific purposes in the future. Money invested through these accounts isn’t taxed in the year it is earned—instead, all contributions and earnings are taxed when the money is taken out.

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Roth IRA and 401(k) accounts are tax-advantaged in a different way. Investments in these accounts are made with money that’s taxed before it is contributed to the account. If certain rules are met, withdrawals from these accounts are not taxed because the taxes were paid up front.

Income on investments not held in tax-advantaged accounts is taxed in the tax year in which it is received, while capital gains aren’t taxed until the asset is sold. This means that growth of the equity in the investment—sometimes the biggest component of gain—isn’t subject to current taxation.

Location and allocation are two different issues

Many investors have holdings in all three kinds of accounts—tax-deferred (traditional retirement accounts and ESAs), tax-already-paid (Roth retirement accounts) and taxable—and that complicates their investment planning decisions. It also complicates the task of coming up with an asset allocation (the decision about how much to hold in different asset classes, such as stocks, bonds, cash equivalents, real estate and other alternative investments).

Many financial services companies don’t provide planning tools that consider assets held outside their institutions. Investors with some retirement funds in 401(k)s held by their employers, among others, might find it difficult to look at their portfolios as a whole if they also have traditional or roll-over IRAs and/or taxable investment accounts.

In addition, money that is held in tax-deferred accounts needs to be counted differently, said Larry Swedroe, principal and co-founder of Buckingham Asset Management. This is because the investor only owns some of the money held in these accounts—the government is, essentially, a silent partner holding the rest. Because the money invested through these accounts wasn’t taxed before it was deposited (or withheld from the investor’s paycheck), taxes will have to be paid when it is withdrawn. The tax money is the government’s share.

When figuring asset allocation, only the investor’s share of holdings in tax-deferred accounts should be counted, Swedroe said. This allows the investor to account for the fact that taxes have already been paid on holdings in Roth accounts. However, coming up with the percentage that belongs to the government is complicated by the crystal ball effect. The correct asset allocation depends in part on what tax bracket the investor will be in when the money is withdrawn, a factor most people cannot know for sure.

What goes where?

Once investors have determined what asset allocation best meets their investing goals and style or what changes need to be made in rebalancing the portfolio, they need to figure out which assets they want to hold in tax-advantaged accounts and which ones to keep in their taxable accounts. The goal here is to create the highest after-tax returns on each investment.

Generally, financial and investment planners recommend holding tax-efficient assets (Ken Hawkins of Second Opinion Investor Services calls them “tax-friendly”) in taxable accounts. This includes equity investments with long-term capital gains and qualified dividends, like those held by investors with buy-and-hold philosophies. Tax-inefficient holdings, such as REITs and collateralized commodity futures, should have preference in tax-advantaged accounts, Swedroe said. Like other investment professionals, he also advises holding higher-returning assets in Roth accounts.

Other assets are in the “middle-efficiency” group. For these investments, the difference in after-tax returns by account type isn’t as large, so the asset location may not make as much difference. Investors can fall back on some rules of thumb: Equities with long-term gains belong in taxable accounts, in part because capital gains are taxed at a lower rate, while bond investments are preferable in IRAs because they don’t have as much growth potential.

Investors with limited funds to shelter in retirement accounts each year—i.e., they can’t fund both Roth and traditional accounts to the maximum allowed and have to decide which account to contribute to—need to consider what tax bracket they are in now and what bracket they expect to be in at withdrawal, Swedroe said. If they expect to be in a lower tax bracket in retirement, they should put the money in a traditional, tax-deferred account. If the tax bracket at withdrawal is likely to be higher, funding the Roth with money already taxed at the lower rate is advisable.

For people who are likely to be in the same tax bracket at deposit and withdrawal, it might be preferable to put retirement funds into the Roth because of the flexibility these accounts offer in timing withdrawals, Swedroe said. This is so because rules for when funds need to be withdrawn from traditional accounts are so strict. Another strategy, Swedroe said, is to diversify—put some contributions into each kind of account. The important thing is to fund retirement accounts to the maximum the investor can afford.

As with most financial planning decisions, the answer to where some assets belong in a portfolio is highly individual. It will depend in part on the size and contents of the portfolio, the investor’s time horizon and the likely tax bracket in retirement.

With all the complications and uncertainties involved in investment planning, some financial planners don’t pay much attention to asset location. Perhaps they should with estimates of 20 to 25 difference after-tax returns, according to the Journal of Finance and the Journal of Financial Planning, among others.

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