Oct 22, 2024 | 6 min read
You're probably focused on choosing the right investments and maximizing your returns. But here's a strategy that could significantly impact your wealth over time, and it's not about what you invest in, but where you put those investments. Welcome to the world of asset location.
What is Asset Location?
Asset location is the practice of strategically placing your investments in different types of accounts to minimize taxes and maximize after-tax returns. It's like organizing your closet, but instead of sorting clothes, you're sorting investments based on their tax efficiency.
The main types of accounts you'll be working with are:
Taxable accounts Regular brokerage accounts where you pay taxes on dividends, interest, and capital gains as they occur.
Tax-deferred accounts Like traditional 401(k)s and IRAs, where you pay taxes only when you withdraw money.
Tax-free accounts Like Roth 401(k)s and Roth IRAs, where you pay taxes upfront but not on withdrawals or growth.
Why Asset Location Matters
According to Vanguard's Advisor's Alpha research, optimized asset location can add up to 0.75% to your annual returns. That might not sound like much, but over decades, it can significantly boost your wealth.
Let's look at some data to see how this works in practice:
On average, asset location can add up to 60 basis points of value annually to a portfolio
Notes: Pre-tax and after-tax returns are based on the following assumptions: taxable bond return, 4.4%; municipal bond return, 3.5%; index equity, 8.3%
(1.8% for dividends, 0.5% for long-term capital gains, and 6.0% for unrealized gains); and active equity, 8.3% (1.8% for dividends, 1.0% for short-term capital
gains, 4.5% for long-term capital gains, and 1.0% for unrealized gains). This analysis uses a marginal U.S. income tax rate of 37% for income and short-term
capital gains and 20% for long-term capital gains and includes the 3.8% Medicare tax on investment income. These values do not assume liquidation. Source: Vanguard
This table shows the impact of different asset location strategies on after-tax returns. Let's break it down:
Row A shows the optimal strategy: placing index equity (which is typically tax-efficient) in taxable accounts, and taxable bonds (which are less tax-efficient) in tax-deferred accounts. This strategy yields a 6.5% after-tax return.
Row B flips this strategy, putting taxable bonds in taxable accounts and equity in tax-deferred accounts. The result? A 0.5% lower after-tax return.
Row C tries to improve on Row B by using municipal bonds, which are tax-exempt at the federal level, in the taxable account. This helps, but still underperforms the optimal strategy by 0.2%.
Row D shows what happens if you use actively managed equity funds (which tend to be less tax-efficient due to higher turnover) in taxable accounts. This performs the worst, with a 0.6% lower after-tax return than the optimal strategy.
The Key Principles of Asset Location
Based on this data, here are some key principles for effective asset location:
Put tax-efficient investments in taxable accounts This includes broad-market stock index funds and ETFs, which tend to have low turnover and mostly qualified dividends.
Use tax-deferred accounts for less tax-efficient investments This includes taxable bonds, REITs, and actively managed funds with high turnover.
Be strategic with municipal bonds While they can be useful in taxable accounts, they may not always be the optimal choice depending on your tax bracket and the yield compared to taxable bonds.
Consider your entire portfolio Asset location decisions should be made in the context of your overall investment strategy and asset allocation.
Implementing Asset Location: A Step-by-Step Approach
Start with your target asset allocation Decide on your overall mix of stocks, bonds, and other assets based on your goals and risk tolerance.
Identify your account types Take inventory of your taxable, tax-deferred, and tax-free accounts.
Prioritize tax-efficient investments for taxable accounts Place broad-market stock index funds here first.
Use tax-deferred accounts for less tax-efficient investments Fill these with taxable bonds, REITs, and any actively managed funds.
Optimize tax-free accounts These are flexible and can hold any type of investment, but are especially valuable for assets with the highest expected returns.
Rebalance across all accounts Treat all your accounts as one big portfolio when rebalancing to maintain your target asset allocation.
Challenges and Considerations
While asset location can be powerful, it's not without challenges:
Complexity Managing multiple accounts and keeping track of your overall asset allocation can be more complex.
Account limitations You might not have access to all types of accounts, or some accounts might have limited investment options.
Changing tax laws Tax laws can change, potentially affecting the optimal asset location strategy.
Personal circumstances Your specific tax situation and financial goals might necessitate a different approach.
Asset Location for Young Professionals
As a young investor, you have a unique opportunity to benefit from smart asset location strategy:
Time is on your side The longer your investment horizon, the more impact tax-efficient investing can have.
Career growth potential As your income (and tax bracket) potentially increases over time, tax-efficient investing becomes even more valuable.
Flexibility You likely have more flexibility to open and manage different types of accounts compared to someone nearing retirement.
Compound growth By maximizing after-tax returns early, you allow more money to compound over time.
The Role of a Financial Advisor
While you can implement asset location strategies on your own, a financial advisor can add significant value:
Expertise They can navigate the complexities of tax laws and investment options.
Holistic view They can ensure your asset location strategy aligns with your overall financial plan.
Ongoing management They can handle the regular rebalancing and adjustments needed to maintain optimal asset location.
Personalization They can tailor the strategy to your specific circumstances and goals.
Final Thoughts
Asset location is a powerful but often overlooked strategy that can significantly boost your after-tax returns over time. By thoughtfully placing your investments in taxable, tax-deferred, and tax-free accounts, you can minimize your tax burden and maximize your wealth accumulation.
Implementing smart asset location strategies now can set you up for substantial long-term benefits. It's not just about what you invest in, but where you put those investments that can make a big difference in your financial future.
Remember, while the principles of asset location are straightforward, implementing them effectively can be complex. Don't hesitate to seek professional advice to ensure you're making the most of this powerful strategy.
For a more comprehensive look at how financial advisors can add value through asset location and other strategies, check out our in-depth blog post: The Hidden Value of Financial Advisors: More Than Just Investment Returns.
At Israilov Financial, we specialize in creating tax-efficient investment strategies, including optimal asset location, to help maximize your long-term returns. If you're interested in learning how we can optimize your portfolio's tax efficiency, schedule your free discovery meeting.
IMPORTANT DISCLAIMERS
Past performance is no guarantee of future returns
The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.
This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.
Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.
As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.
Comments