Asset Location Strategies

Institutional Asset Management

 Peter Lazaroff By: Peter Lazaroff

Everyone is thrilled that tax season is behind us. Now it’s time to focus on future tax bills.

A commonly overlooked aspect of portfolio management is the opportunity to apply asset location strategies to enhance after-tax returns. Several studies (examples here and here) demonstrate a significant increase in retirement income as the result of proper asset location. Plus, proposed tax increases make these strategies even more important.

Different types of investments receive different tax treatment. For example, the interest paid by bonds are taxed as ordinary income whereas dividends and capital gains from stocks are taxed at more favorable rates. Applying asset location strategies to maximize after-tax returns requires an investor to determine which securities belong in a tax-deferred account and which should be held in taxable accounts.

The answer isn’t necessarily the same for every investor. Plancorp considers several variables in applying asset location strategies such as the tax treatment and risk/return characteristics of the investment, financial profile and tax bracket of the investor, time horizon for the portfolio, and current tax law.

In general, it is best to hold stocks in taxable accounts while filling tax-deferred accounts with investments that generate ordinary income. This makes sense given that dividends received and capital gains realized from stock investments are taxed at a lower rate than fixed income investments that are taxed as ordinary income.

Holding stocks in taxable accounts also gives investors greater control over the timing of their taxes. Unlike a bond that makes regular interest payments subject to taxes, investors don’t pay taxes on capital gains until the security is sold. In other words, an investor can delay capital gains tax on a stock by choosing not to sell it. From an estate planning perspective, holding a stock in a taxable account until death results in a step-up in cost basis, eliminating capital gain taxes for you and your heirs.

Another advantage of holding stocks in taxable accounts is the ability to harvest losses for tax purposes. Imagine you purchase 1,000 shares of XYZ at $100. If the stock price falls to $90 and you sell XYZ at a $10,000 loss ($10 loss x 1,000 shares of XYZ = $10,000 loss), you are able to use the loss to lower current year income and offset future capital gains. When it comes to taking losses, the ability to harvest losses for tax purposes is greater when the asset class is more volatile – and obviously stocks are more volatile than bonds.

The advantages of holding stocks in taxable accounts are extended further for charitably inclined investors. Donating appreciated stock is better than writing a check because any capital gains on a gifted stock is not taxable to the investor/donor. This strategy tends to be most valuable for stocks in a taxable account since their expected return (and thus potential for capital gains) is higher relative to bonds in a taxable account.

The major exception to the rule of holding equities in a taxable account is with Real Estate Investment Trusts (REITs). The majority of return from REITs is in the form of distributions that are taxed as ordinary income rather than dividends, making them less tax efficient than other equity classes. As a result, REITs should be placed in tax-deferred accounts when possible.

In theory asset location strategies are straight forward. In practice, however, the mix of taxable and tax-deferred assets as well as the portfolio’s allocation rarely allows for perfect implementation. In addition, the financial profile and tax-bracket for the investor impact how aggressively asset location strategies are pursued. For example, an investor in the 15% tax bracket gets significantly less benefit from asset location than an investor in the 39.6% marginal tax bracket.

Another important consideration is the investor’s proximity to retirement and liquidity needs in retirement. Withdrawal sourcing is a full topic for another day, but it is worth mentioning briefly in this context. Withdrawals for retirement typically start in taxable accounts until mandatory withdrawals from tax-deferred accounts occur, but this could leave a lopsided asset allocation if withdrawals are repeatedly coming from the same account and, possibly, the same asset class. In addition, a thoughtful withdrawal strategy will consider tax liabilities on an annual basis and look for opportunities to keep you in a lower tax bracket.

In short, there is rarely a cookie cutter solution for implementing asset location strategies, but there are usually some opportunities for investors to enhance after-tax returns.

Since the benefit of asset location isn’t reflected on investment statements, it is not surprising that asset location is so frequently overlooked by investors. Hopefully this information has given you a better idea of some of the behind-the-scenes items we are doing with our financial planning.

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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

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Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »