Summary/TL;DR
Having an asset location strategy means optimizing your portfolio for tax efficiency by holding investments in accounts that align with their tax characteristics. Bonds and other fixed income assets, being tax inefficient and having low growth, are best held in pre-tax retirement accounts while stocks and Bitcoin are more appropriate for Roth and after-tax accounts. Over time, this can make a tremendous impact to your lifetime tax bill and how much of your legacy stays within your family after your passing.
Introduction
Almost everyone knows about the importance of “asset allocation”, which teaches that a diversified portfolio of securities can reduce risk and improve returns over time. What doesn’t get talked about as much, but can be nearly as impactful, is asset location.
Today’s post is all about the importance of asset location and its long-term impact.
What Does It Mean To Optimize Asset Location?
Asset location refers to what kind of tax-environment different assets are held in. For example, you might own stocks in a brokerage account, Traditional IRA, Roth IRA, or all three. You might only hold cash in your savings account while choosing to keep it at a minimum in your investment accounts. Most people hold rental real estate in their personal name instead of a self-directed IRA. All of these decisions can be very important from a tax perspective because the nature in which these assets are held will determine how you pay taxes on their growth and income.
It's common knowledge that investment accounts are taxed differently, and that each has their own advantages and disadvantages. In short, there are three broad categories – pre-tax savings, Roth savings, and after-tax (sometimes called “taxable”) savings. Pre-tax savings is commonly made through an employer retirement account or Traditional IRA. Savings are deducted from one’s personal income and all income and growth on the investments are tax-deferred until distributed, at which point they are taxable as ordinary income. Roth savings aren’t deductible, but all growth and income is tax-free as long as the account is open for at least five years. Finally, savings into after-tax accounts also aren’t deductible, and income and growth are taxed at either ordinary income or long-term capital gains rates. Long-term capital gains rates are far more favorable than ordinary income rates, which can create some instances in which after-tax accounts are preferred to pre-tax accounts for tax-efficiency.
Furthermore, some assets are more “tax efficient” than others. Mutual funds distribute capital gains once per year, bonds and bond funds typically pay out interest quarterly or monthly, many stocks make dividend distributions once per quarter, depreciation may be claimed against rental real estate, and some assets (such as tech stocks) have much higher long-term growth prospects than others (such as bonds or stocks of utility companies). Realizing that the tax efficiency of various investments makes them more or less suitable for different account types is the heart of a sound asset location strategy.
Asset Location In Practice
In practice, asset location involves holding various investments within the account that best compliments their tax efficiency and future growth prospects.
For example, stocks and Bitcoin, being long-term growth assets, are best held in Roth IRAs or after-tax accounts. If held in a Roth, all growth will be tax free and, if held in an after-tax account, all growth will be subject to long-term capital gains tax if held for longer than one year. Likewise, low-growth assets (which are also ones that pay out taxable interest) are best held in pre-tax retirement accounts. This way, you take advantage of the tax deduction when you make the savings, but minimize the tax liability on the growth and interest. Rental real estate, on the other hand, has multiple tax advantages that become nullified if they are held in a pre-tax or Roth account, making them most suitable for after-tax ownership.
While portfolio distribution needs could place limitations on being able to exercise this strategy perfectly, the general principles of sound asset location can still be used to optimize one’s portfolio in any given set of circumstances.
Example Of Asset Location
A good asset allocation strategy is another example of a small change which can make a large difference over time. The examples below will show two scenarios with a $2,000,000 beginning portfolio balance averaging 7% over 20 years. In the first scenario, no asset allocation strategy is pursued and the after-tax value of the total portfolio ends at about $7.275M.
In the second example, a more intentional asset allocation strategy is pursued, with conservative investments held exclusively in the Traditional IRA and aggressive investments held exclusively in the Roth IRA. The result is an ending after-tax portfolio balance of almost $8.7M.
While these examples are oversimplified, they effectively demonstrate how the principles of asset location strategies can make a material difference to one’s long-term investment plan. Not discussed, but still very important, is the difference that these changes will make to your heirs when they inherit your portfolio. Generally, retirement portfolios of any kind must be distributed within ten years of inheriting the funds. If the funds are in a pre-tax account, then the distributions will be taxable. If they’re in a Roth, the distributions will be tax-free. Therefore, good asset location has not only saved you a ton in taxes, but it will also keep more of your legacy in the family!
