September 28, 2020

The last time you heard the phrase “location, location, location” was probably from your real estate agent when buying or selling your home. But when was the last time you heard this same mantra from your investment advisor or financial planner?

Asset location, not to be confused with asset allocation, is a term for strategically locating your investments into different investment accounts. By strategically placing assets into the correct accounts, the tax efficiency and overall after-tax investment returns of the entire (taxable and non-taxable) portfolio can be optimized. The resulting, highly tax efficient, portfolio may save a tremendous amount of tax dollars over a long-term investment horizon.

How Does Asset Location Work?

At a 30,000 foot level, the first step is to focus on the asset allocation plan and ensure it includes consideration of all investment assets, regardless of whether such assets are located in a taxable, tax deferred, and non-taxable account.

The next step, which in my experience does not always take place, poses the elusive question of: “Where should my individual stocks, exchange traded funds, and taxable and municipal bonds and annuities be located to reduce my future pay out to Uncle Sam?”

A simple example may be helpful to better understand the power of proper asset location. Let’s say that Rick has $2 million split evenly between his IRA and a taxable investment account. The IRA account includes $1 million, which is invested with a highly regarded equity manager who employs a buy and hold strategy, and thus very rarely sells any of his core stock holdings (think Warren Buffet). On the other hand, Rick’s taxable investment account includes another $1 million of very highly rated taxable bonds. For sake of argument and brevity, let’s also assume that after a thorough asset allocation study, the recommended asset allocation on an overall basis was exactly the same as how the current overall portfolio is allocated, which again was 50% to the buy and hold stock or equity manager and 50% to highly rated bonds of defined durations.

By simply flip-flopping the $1 million stock and bond portfolios between the IRA and taxable investment account, Rick could avoid reporting $50,000 of annual taxable interest, and thus avoid paying approximately $17,500 of additional tax each year. Yes, after the flip-flop Rick would then have to report any taxable dividends from the rock star buy and hold equity manger, but, under today’s tax law, dividends receive preferential tax treatment and are taxed at a maximum federal income tax rate of 23.8%, so the perfect location for the equity manager is in the taxable investment account.

Obviously the above is a very simple example, but a general rule of thumb is the following:

  • Locate the most tax disadvantaged assets into the most tax advantaged investment vehicles.
  • REIT’s, fully taxable bonds, and active fund equity managers producing an abundance of short-term gains might be good candidates for tax deferred (IRA) or tax-exempt (Roth IRA) types of accounts.
  • Municipal bonds, long term “buy and hold” equity managers, and ETFs would be appropriate for taxable accounts.

There are many additional items of personal consideration when crafting the proper asset location game plan, so engaging an experienced financial professional is recommended.

Lastly, do keep in mind that the financial benefit of proper asset location may become even more magnified if there is change in the White House on November 3rd , or if for any reason there are future increases in federal or state income tax rates or your personal tax situation. If you have any questions regarding your asset location, contact your financial advisor or a Clark Nuber professional.

© Clark Nuber PS, 2020. All Rights Reserved

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.