Demystifying Asset Location

A Simple, Practical Approach to Maximize Your Portfolio's Tax Efficiency

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Ryan A. Hughes
April 20, 2023
Asset Location Strategy

You may be familiar with the concept of asset location. It’s a tax planning strategy that can help you optimize your investment portfolio’s tax efficiency. But despite the potential benefits, many argue that it’s not worth the effort due to its complexity and uncertain outcomes.

We agree. There is a more straightforward alternative approach that suits your financial goals better.

Understanding Asset Location

Asset location is all about placing specific investments or asset classes in certain accounts to minimize the tax burden on your investment returns. It takes into account the different tax treatments for various accounts, such as traditional 401(k)s, Roth IRAs, and taxable accounts.

While asset allocation refers to the mix of different asset classes within a portfolio, asset location focuses on the placement of those assets in specific accounts. For example, tax-efficient investments like index funds or municipal bonds might be held in taxable accounts, while tax-inefficient investments like actively managed funds or high-yield bonds might be held in tax-deferred accounts like IRAs or 401(k)s.

The Theory Behind Asset Location

Asset location strategies are based on the different tax rules for each account type:

  1. Taxable accounts (brokerage, joint, trust, etc.) are the least tax-efficient.
  2.  Tax-deferred accounts (IRA, 401(k), etc.) allow you to defer income and not pay any taxes on investments within the account. However, withdrawals are taxed at the highest rate.
  3.  Tax-free accounts (Roth IRA, Roth 401(k), etc.) are funded with after-tax dollars, but grow tax-free and can be withdrawn tax-free.
ASSET LOCATION SPECTRUM: Bull Oak Capital

A typical asset location strategy might involve placing interest-bearing investments in tax-deferred or tax-free accounts, U.S. stocks and municipal bonds in taxable accounts, and foreign dividend-paying stocks in tax-deferred accounts.

The Problem with Asset Location

Despite the potential for increased returns, asset location has two major issues:

Difficulty in Predicting Future Returns

Asset location relies on expected future returns, which are challenging to predict (not surprising). If actual returns vary significantly from expectations, the strategy’s effectiveness can be compromised.

Take, for example, small-cap value stocks and Roth IRAs. Under the rules of asset location, it is tempting to place these stocks in a Roth IRA account as it offers the most upside potential.

However, what if small-cap value stocks significantly underperform for a decade or two (this has happened before), then is it really the optimal strategy? Hardly.

To no one’s surprise, stock returns are a bit difficult to predict.

Regulatory Risk

Tax laws and regulations can change, which could impact the optimal asset location strategy. For instance, if tax rates on U.S. dividends or capital gains were to increase, a previously optimal asset placement could become suboptimal.

The Simpler Alternative: Keep It Simple

Considering the challenges and uncertainties associated with asset location, a simpler approach may be more practical for many investors. Instead of trying to optimize asset location, focus on asset allocation and hold the same mix of assets across all accounts.

Asset Location Keep It Simple

For example, if your target asset allocation is 60% stocks and 40% bonds, maintain the same 60/40 portfolio in your taxable, tax-deferred, and tax-free accounts. This simple approach eliminates the need for complex forecasting and reduces the risk of suboptimal outcomes due to unpredictable changes in returns or tax regulations.

MINIMIZING TAXES

Because we choose not to participate in tax location for our clients does not meant that we are not minimizing taxes. The opposite is true. We invest almost exclusively in index ETFs, which are known for their tax efficiency due to their unique structure and how they are managed.

  • In-Kind Creation: ETFs are designed so that authorized participants (APs) can create and redeem shares directly with the fund provider in large blocks, called creation units. When an AP creates or redeems shares, they typically do so in-kind, exchanging a basket of the underlying securities for ETF shares or vice versa, rather than in cash. This in-kind process helps avoid triggering capital gains taxes for the ETF because it is not considered a taxable event.
  • Lower turnover: Most ETFs, particularly those that track an index, tend to have lower turnover rates compared to actively managed mutual funds. Lower turnover means fewer transactions within the fund, which results in fewer capital gains being generated. As a result, ETFs can defer capital gains taxes for longer periods, allowing investors to enjoy the benefits of compounding without being weighed down by taxes.
  • Pass-through of capital gains: When an ETF does realize capital gains, it can pass those gains directly through to its shareholders. This means that shareholders are only responsible for paying taxes on any gains they realize when they sell their ETF shares, as opposed to mutual funds, where shareholders may also have to pay taxes on gains realized by the fund itself even if they haven’t sold their shares.
  • Tax loss harvesting: Some ETFs take advantage of a strategy called tax loss harvesting, which involves selling securities that have lost value to offset gains from other investments. This can help reduce the overall taxable gains within the ETF, providing a more tax-efficient experience for investors.

Align goals with account type

In many instances, we will match up a client’s goals with the appropriate account type. For example, if a client has a Roth IRA account which they will likely never use, then it probably makes sense to invest these funds aggressively, whereas the rest of their portfolio may be invested more moderately.

However, we won’t simply choose individual asset classes for the Roth IRA, but rather ensure that it is diversified appropriately.

Conclusion

While asset location can offer potential benefits for some investors, it’s important to weigh the uncertainties, risks, and complexities it brings. For many, adopting a simpler strategy that focuses on asset allocation across all accounts might be a more effective and manageable approach. Remember: don’t let the tax tail wag the investment dog. Keep your strategy simple and focused on your long-term financial goals.

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