Location, location, location. Where your investments are “located” – in taxable vs. tax-advantaged accounts – can affect your total after-tax return significantly. But knowing what to put where – known as “asset location” – is a challenge.
Specifically, the challenge is this: Determining what type of investments to put in each of the account types shown below. As you can see, it’s a matter of balancing the pros and the cons given your individual circumstances, without losing sight of your overall long-term asset allocation.
|Most accounts outside of retirement plans.||Easy access to money.
Tax write-off for losses.
|Annual taxes on income.
Taxes on capital gains.
|Traditional IRAs, 401(k)s and most other types of retirement accounts.||Tax break on contributions.
Assets grow tax-free in account.
|Restricted access to age 59 1/2.
Withdrawals taxed as
Required minimum distributions (RMDs) starting at age 70 1/2.
|Roth IRAs||Assets grow tax-free.
Qualified distributions are tax-free. No RMDs.
|No tax break for contributions.
Restricted access for five years and until age 59 1/2.
*For specifics on 2013-2014 taxes, see this article by LNWM’s Kristi Mathisen.
Various studies and papers have attempted to quantify the benefit of asset location strategies. A March 2014 report by Vanguard Research, for example, estimates that the benefit of asset location for certain investors can be as high as 0.70% annually, and other studies echo this, although the estimated benefit usually ranges from 0.25% to 0.50%.
While 50 basis points (0.50%) may not seem like much, over time it really does add up, especially given our historically low bond yields and a rather tepid 4.5% annualized return on the S&P 500 since 2000.
What’s more, most investors can benefit from smart asset location, even those who have virtually all their assets in retirement accounts. However, the maximum benefits are likely to accrue to people in the following situation:
(1) Sizable investments in both taxable and tax-advantaged accounts, including 401(k)s, IRAs and Roth IRAs;
(2) In the higher income tax brackets (25% and above); and
(3) Diversified portfolios that include most major asset classes (stocks, bonds, alternative assets, etc.).
Despite the potential benefits, asset-location strategies are relatively underutilized in improving after-tax returns. And when such strategies are implemented, this is often done haphazardly or sporadically, without an overall plan in mind.
A lot of Different Variables
LNWM has been implementing asset location strategies for decades. There is a wide variety of factors that go into our decision-making process, including what’s shown in the table below.
What to Consider
|PERSONAL||PORTFOLIO||TAX PROFILE||CASH FLOW|
|Your age & health||Size of taxable, tax-deferred and tax-free accounts||Your tax rate now||Current rate of withdrawal|
|Estate size||Overall asset allocation||Estimated future tax rate||Future cash flow requirements|
|Beneficiaries||Current asset allocation in each account type||Cost basis in your taxable accounts||Likelihood of depleting each account type|
|Charitable intent||Current investments in each account type||Likelihood of converting IRAs to Roth IRAs||Required Minimum Distributions|
Usually, studies on asset location make recommendations based on an overly simplified set of variables that do not change over time. For one, the tax rates used in many studies are fixed at the top rate for capital gains (now 20%) and the top rate on income (39.6%), even though these rates often vary for each investor, as do all the considerations shown above.
In Part II of this post, we discuss three approaches to asset location, as well as some key takeaways.