It is almost a “mantra” by now that Asset Allocation is a critically important decision in designing the correct portfolio. That truth sometimes obscures another important decision for clients accumulating for or commencing a retirement drawdown – Asset Location is a second important focus. By “Asset Location” we mean: “What is the optimum account location (tax-deferred account or after-tax account) for various types of investments?”
Many investors, after working through the exercise of determining an Asset Allocation, finally reach the finish line and reach an answer. They determine they may need to own 12-15 different investment securities to properly implement their desired investment policy plan and asset allocation. Often, these investors have multiple accounts – IRAs, 401ks, after-tax brokerage accounts (and maybe all three for both spouses). This begs the follow-up question: “Shouldn’t all of the accounts in the household be invested similarly and own all 15 investments?” There are a variety of considerations that ultimately depend on each family’s unique circumstances, but many times the answer is “No”. Several general observations can be made which may help produce clarity on why each account should NOT own all the investments for the allocation in similar proportions.
- There may be a cost advantage in thoughtful asset location. Assume it requires 15 different investment securities (stocks, bonds, mutual funds, ETFs) to properly build a diversified portfolio that achieves the desired investment posture (40% bonds/60% equities as an example).
- If each of the three accounts purchases all 15 of these securities in the same proportions, it will increase the trading costs for the investor at the time the portfolio is created and each time there is a need to re-balance or raise cash for distribution out of one of the portfolios. Although today’s trading costs when using discount brokerage can be very minimal, they nonetheless add up over time and therefore reducing them is an advantage.
- It therefore often makes more sense to hold the 15 required investments across the combination of the 3 accounts rather than to duplicate each holding in all 3 accounts and hold 45 different positions.
- There may also be income-tax advantages in strategic location of investments. Some investments are simply better held within an IRA account rather than inside a taxable brokerage account, once income tax considerations are taken into account. Take for example an investor who’s in a high marginal income tax bracket and has created an investment policy calling for both tax-free municipal bonds and also some high-yield corporate bonds. This investor is likely to be best served by holding the tax-free municipal bonds in the taxable brokerage account while holding the taxable high-yield corporate bonds in the IRA account.
- In addition, there may be estate planning considerations which dictate careful asset placement decisions. With today’s larger $5+ million estate tax exemptions, many families are paying more attention to minimizing income taxes as distinguished from estate taxes when property passes to the next generation. Given this reality, it can make a lot of sense to hold assets that are likely to appreciate (stocks) in the after-tax account while holding assets with little appreciation potential (bonds) in the tax-deferred accounts. When the estate assets move to the second generation of the family, the (hopefully) appreciated stocks will enjoy a stepped up cost basis, saving the family potentially many years’ worth of capital gains taxes.
Getting the Asset Allocation right is certainly an important decision. But the investor and their advice team should be thoughtful and prudent in making the Asset LOCATION decisions which may be equally important to long-term success of the strategy.
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