Portfolio Tax Planning 201: Asset Location

A desirable location can significantly increase the value of a property. For example, a beachfront residence would be worth more than the same residence 30 miles inland (all other factors equal). Similarly, when it comes to your portfolio, finding a desirable location for different types of assets can increase its overall value.

Portfolio taxation is a key area that is often overlooked by investors. Many people are familiar with basic asset allocation – selecting an appropriate blend of stocks, bonds, and other asset classes to create a portfolio that matches their risk tolerance.

Unfortunately, this is where many people stop, leaving their portfolio susceptible to a higher level of tax drag (the portion of your portfolio returns that are lost to taxes). In order to maximize your take-home portfolio value, we need to reduce tax drag as much as possible.

This is where asset location comes into play.

Asset location refers to how you distribute individual investments across different types of accounts. For a refresher on the three major account categories (taxable, tax-deferred, and tax exempt), check out this post.

According to research done by Vanguard, proper asset location can add up to 0.75% of value to your portfolio per year. While 0.75% may not seem like a lot in any given year, this can add up to a relatively significant amount when compounded over time. For example, if you started with $1,000,000 in your portfolio and added 0.75% of value per year for 20 years, you would end up with an extra $161,184. Not too shabby!

Understanding the importance of asset location, what steps can we take to add this value to our portfolios? While there is no perfect “one size fits all” solution, as everybody has their own unique situation, there are a few tricks that can help you maximize your portfolio’s tax efficiency:

• Use higher income producing asset classes, such as corporate bonds, in your tax-deferred accounts. Since interest income from these types of bonds are taxed at your ordinary rate, using a tax-deferred account for these assets can significantly reduce your tax liability (especially if you are in a higher tax bracket). Additionally, you can consider holding more growth focused asset classes, such as stocks, in your taxable accounts. 

• Implement more passive investment strategies in your taxable accounts, and more active investment strategies in your tax-deferred and tax-exempt accounts. When you sell a holding in your account, it can result in a capital gain. The more active an investment strategy, the higher the potential for capital gains. With tax-advantaged accounts, you are able to avoid paying taxes on these gains until money is withdrawn, enhancing the compounding effect while growing your portfolio.

• Be more aggressive in your taxable and tax-exempt accounts, and more conservative in your tax-deferred accounts. While this may not necessarily have a direct impact on your portfolio today, a more conservative allocation across your tax-deferred accounts can help minimize Required Minimum Distributions (RMDs) during your retirement years. By reducing the risk in your tax-deferred accounts, you may be able to afford to be more aggressive in your taxable and tax-exempt accounts. You’ll receive the preferential tax treatment of capital gains in your taxable accounts (assuming the security is held for more than 12 months) and there won’t be any taxation on the gains within your tax-exempt account.

While this is not an all-inclusive list, these are some easy steps you can take to more efficiently manage taxes in your portfolio. 

Effective tax planning not only considers how your accounts are set up today, but also considers how accounts will be set up in the future. It’s never too late to review your portfolio and make the proper adjustments to set it up for long-term success. Even something as simple as constructing a Roth conversion strategy can get your portfolio pointed in the right direction to take advantage of appropriate asset location.

Generally, the largest tax savings benefits can occur when you have multiple account types (such as a Traditional IRA, Roth IRA, and Individual Brokerage account).

So remember, while selecting an appropriate asset allocation is important, you still need to consider location, location, location.

Derek Prusa, CFA, CFP® and Ben Webster, CFP®

Co-Founders and Owners of Aspire Wealth