When it comes to portfolio construction best practices, most of us are aware of the benefits of asset allocation and diversification. But with tax-deferred retirement accounts becoming an ever-larger part of the average investor’s investment portfolio, asset location has arguably become just as important as its much more famous allocation-focused cousin. According to research from Vanguard, proper asset location techniques could add as much as 1% annually to investment returns over the long run, all without taking an ounce more risk.
At its core, asset location is a tax minimization strategy that aims to optimize the benefits of tax-deferred retirement accounts. By taking advantage of the fact that different investments receive different tax treatment from the IRS, asset location strategies are able to direct the appropriate assets to their proper investment vehicles, so as to minimize the “tax drag” on investment returns.
How does it work?
The most basic asset location prescription is to hold tax-inefficient assets (bonds, REITs, preferred stock) in tax-deferred accounts, and to hold tax-efficient assets (index funds, most ETFs) in taxable accounts. Since the primary purpose of a tax-deferred account is, of course, to defer taxes, it should be clear that those assets which would otherwise generate the largest recurring taxable gains should be concentrated in these tax-deferred accounts. So, any investment that tosses off a significant amount of annual interest should ideally be held in a 401(k) or an IRA.
But there is another equally important point to be made here. Investments like stocks, which are typically held for a number of years (if not decades), can generally qualify for long-term capital gains treatment, which means a lower tax on the gain than would otherwise stem from the (higher) ordinary income tax rates. For those in the lowest tax brackets, the long-term capital gains tax could even be zero. However, if those stocks are held in a tax-deferred retirement account like a 401(k), then the gains on those assets will ultimately be taxed at ordinary income rates, since all withdrawals from tax-deferred accounts are taxed as ordinary income, regardless of the original source of those earnings.
It’s also worth noting that for dividend-paying stocks, most dividends also enjoy long-term capital gains treatment as “qualified dividends”. Therefore, even if your stock (or stock fund) is throwing off a lot of income in the form of dividends, that doesn’t necessarily mean it should be stashed in your IRA along with the rest of your income-generating assets. It’s important to think about how the investment income would be taxed if it were held in a taxable account. If it would be taxed as ordinary income, then it’s probably best stashed in a tax-deferred retirement account; if it would qualify for long-term capital gains treatment, then it’s better off in a taxable brokerage account.
Who can benefit?
Anyone who has investments in both taxable and tax-deferred accounts can avail themselves of the benefits of asset location. Generally, an even split between taxable and tax-deferred assets will be optimal, but the benefits will vary depending on the investor’s overall portfolio allocation.
For example, if Investor A is a 25-year-old worker with an 80% portfolio allocation to stocks, but 90% of his investment assets are held in his company’s 401(k) plan, then he’ll have no choice but to hold the majority of his stocks in a tax-deferred account, since it’s all he has. On the other hand, if Investor B is a 60-year-old retiring entrepreneur with a 70% allocation to bonds, but who never set up a 401(k) plan for himself at work, and therefore holds 80% of his investments in his taxable brokerage account, then he’ll face the same problem in the opposite direction—he’ll be forced to hold bonds in his taxable brokerage account, where he’ll be subject to taxation as the interest income is earned.
But in these sorts of cases, not all is lost. Investor B, for example, could consider investing a portion of his taxable account in municipal bonds, which enjoy tax-exempt status. Investor A, meanwhile, could have more freedom to invest in certain tax-inefficient stock funds, such as actively managed mutual funds, which typically generate more ongoing income than their passively managed companions.
What are the potential drawbacks?
In addition to the potential investment type/account type mismatch mentioned above, there are certain other drawbacks to asset location strategies. For one, if an investor is dependent upon the income that his investment portfolio provides, then it won’t be optimal to shield all of the income-generating assets in a tax shelter account. This dynamic can typically be most pertinent for early retirees, who may no longer be earning salaries but who are unable to fully access the funds in their retirement accounts because of their age (since withdrawals from tax-deferred plans typically carry a tax penalty until age 59 ½).
Also, since stocks are typically more volatile than bonds, if your taxable account holds nothing but stocks, then your liquidity may suffer, and you may find that your money isn’t accessible when you need it because your most-accessible investments are also your most volatile (i.e. least reliable). Therefore, for those investors who adopt a particularly extreme asset location slant, it might be advisable to hold a bit of extra cash in an emergency fund, so as to guard against those liquidity concerns.
Another consideration would involve investment or fund choice—if the bond fund options in a workplace 401(k) plan are unattractive from a risk-reward standpoint (as compared to the alternatives in a taxable account), then the benefits of asset location may not be sufficient to overcome the negative portfolio effects of a suboptimal investment. You don’t want to hold onto a bad investment just because it’s theoretically tax-optimal—remember, choose your investments first, and then think about tax treatment, never the other way around. Don’t let the tax tail wag the investment dog.
It bears mentioning that asset location strategies are somewhat complex, including some issues that are more intricate and nuanced than an article of this length can address. For most investors, it will be difficult to set the time aside (or have the relevant expertise) to get the details right. But this is one area where the help of a qualified advisor can ultimately make a big difference. At Cypress, we incorporate the asset location philosophy when building out portfolios for all of our clients, and we’d be happy to help you consider how and where to use it best.
Regardless, if you have a tax-advantaged retirement account, you should know how it does and doesn’t work for you. If you don’t give thought to the full long-term tax implications of investing in a tax-sheltered account, then you could ironically be better off not investing in one at all. Don’t be that investor.