By Peter Mastrantuono
Asset allocation is not the only important element of a strategic investment plan. Overlooked by many investors is the decision of where to locate those asset class allocations.
Where asset allocation is about how to divide your investments among different asset classes, asset location is about where to best place the investments in these asset classes, e.g., a taxable brokerage account, 401(k), IRA, etc.
Consider this simple illustration. Based on an individual’s risk tolerance, time horizon and investment objective, the most suitable asset allocation for our hypothetical investor is 50% stocks and 50% bonds.
Many investors are likely to execute on this asset allocation by holding a 50/50 portfolio in each of their investment accounts. There is no rule, however, that says an asset allocation needs to be uniformly expressed in each account. Indeed, it may be more tax efficient if investors assign the 50% equity exposure to their tax-deferred accounts and target the 50% bond allocation to their taxable accounts.
Of course, the relative values of each account type may not allow a clean and complete asset location execution as implied by the above example, but to the extent that investors can be smart about what accounts get which assets, the resulting tax efficiency may add up to a real wealth difference at retirement.
Asset Location: General Guidelines to Consider
Here are some guidelines to consider when making decisions about where to best locate investments. Because each individual situation is different, a financial advisor can be helpful in sorting through these considerations to determine the best strategy for you.
- Investments with higher expected returns generally should be held in a tax-deferred account since dividends and capital gains can be reinvested without the drag of current taxation.
- Investments with low tax efficiency, for example an actively managed stock mutual fund or income-oriented REIT, should be held in tax-deferred accounts.
- Not all IRAs are created equal. The traditional IRA and Roth IRA have different tax consequences on distributions from each. Roth IRA withdrawals are generally tax-free, while traditional IRA distributions are generally subject to income taxes. This may mean that Roth IRAs get preference for the higher expected return investments.
- As an investor reaches the age of 72 or higher, if he or she has an RMD (Required Minimum Distribution) problem, then it may be beneficial to place lower yielding bonds in his or her IRA to slow its growth and minimize RMDs.
- Tax-efficient investments, e.g., a passively managed index fund, may be best held in a taxable account.
There are exceptions to these guidelines. For instance, if an investor prefers to use appreciated stock to make charitable contributions, then that investment will need to be held in a taxable account.
It should also be noted that these general guidelines do not apply in all scenarios since portfolio turnover (the selling and buying of investments) and time horizon will materially impact where best to locate assets. Generally speaking, the longer the time horizon and the greater the portfolio turnover, the more beneficial it may be to hold equity allocations in a tax-deferred account.
As complicated as the asset location decision may be, it can be rewarding to investors over the long term, so be sure to start a conversation about asset location when you next speak with your financial advisor.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.