Bob French, CFA

The Art of Asset Location

You’ve probably heard a realtor or businessperson tell you that the three most important factors in determining a property’s value are location, location, and location. It seems crazy when you think about it, but it is so true.

There’s a similar (though less adamant) rule for investments: asset location. Where your assets are located within your portfolio matters. Because your different accounts are taxed differently, how you place your assets can have a significant impact on your after tax wealth – and consequently your retirement income.

Taxes can take a deep cut, which makes asset location one of the top ways you can improve your portfolio from a portfolio management perspective. And while this sounds complicated, it is pretty straightforward when you sit down with it for a few minutes. If you can do a jigsaw puzzle, you can correctly locate your assets.

What Is Asset Location?

We can begin by looking at what asset location is not: It should not be confused with asset allocation. They’re related, but kind of in that same way you’re related to that distant cousin whose name you can never remember.

Asset allocation is how you divide up your money between separate asset classes. It is primarily focused on managing risk and returns. One example would be a 50/50 allocation, meaning your portfolio is 50% stocks and 50% bonds. You can also subdivide your stocks further into international or US, small or large companies, and so on.

Asset location is where you put your stocks, bonds and other holdings within your taxable and tax-sheltered accounts. It is primarily focused on maximizing the total overall tax efficiency of your portfolio.

What’s The Point Of Asset Location?

Investing professionals are always disagreeing about something, but asset location is pretty much universally considered to be worth the extra effort.

Over at “Nerd’s Eye View,” Michael Kitces points to a Morningstar analysis showing that a well-executed asset location strategy can add as much as a half-percent to your bottom line each year. That’s $500/year for every $100,000 invested (which could cover a good chunk of your investment expenses).

That’s your money, and you deserve to keep it. You don’t want to just hand it over to the government when you don’t have to.

By putting your most heavily taxed investments in tax-sheltered accounts, you can minimize or possibly eliminate their tax inefficiencies. That seems simple enough, right? But it’s not as easy to put that plan into action as you might think.

First, your tax-sheltered accounts have limited space. If they didn’t, we’d just put all of our money there and call it a day. In reality, challenging-tradeoffs have to be made to make sure you’re making the most of your tax-sheltered “space.”

But it’s not just about sheltering your assets from taxes. You’re going to need those assets available at certain times to achieve your personal goals, and that can be a sticky situation when it comes to tax-sheltered accounts. There are a lot of plates to keep spinning, including:

  • Managing within the context of your bigger picture – Before you decide where your assets should live, you need to determine your proper allocation based on your unique goals and risk tolerances. Allocation needs to always come before location.
  • Planning for your goals and timeframe – How far are you from retirement? What’s your legacy plan? What upcoming changes in health, finances, or location are you expecting? Asset location is important, but it rightly plays second fiddle to withdrawal issues, estate planning, and other needs.
  • Managing tax-sheltered accounts – What kind of tax-sheltered account opportunities do you have: Roth, traditional IRAs, or company retirement plans? How much room does each one have for holding assets, and which kind of accounts will get you the most tax-efficient bang for your buck? Has the tax code changed at all (it is constantly evolving) and what does that mean for your plans?
  • Considering other tax-planning needs – We also look at what benefits could be gained from holding stocks within taxable accounts: Can you harvest capital losses against capital gains? What about donating appreciated shares to charity? When is the right time to implement a step-up in basis? Could foreign tax credits be implemented? The importance of these opportunities depend considerably on your goals and circumstances, but you lose all of these options for your stocks once they’re in tax-sheltered accounts.

Never Heard Of Asset Location? There’s A Reason

Asset location doesn’t get much love in the financial press. To be honest, it’s not that sexy. It’s not going to make you rich overnight, and it’s not going to ruin your portfolio if you ignore it. It’s a very practical, “boring” topic (although we get pretty excited about it around here).

You’ll typically only see it discussed by folks who take a holistic approach to their investments, and who can watch over the entirety of their holdings from a systematic perspective. If you don’t get that kind of help, you’ll find:

  • Missing Pieces – Asset location works best when your entire financial picture is considered. Over the years, your multiple accounts, providers and assets can spread out considerably. It’s hard to get a cohesive picture without both approaching your investments from a holistic perspective, and considering how your investments fit into your broader retirement income plan.
  • Missing Expertise – Even if you have a clear picture of your varied accounts and holdings, asset location is not a “plug and play” solution. Finding your ideal answer is both an art and a science when considering all of your unique, often complex wealth management needs.
  • Missing Oversight – Asset location is not a one-and-done process. The constant evolution of the market, government regulations, and your own goals require ongoing coordination to keep everything running efficiently.

Most investors don’t understand or realize that they’re missing out on efficient asset location, but the money they’re losing is very real and very unnecessary.

Next, read Why Investing During Retirement is Different.

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