In our previous blog post we discussed the benefits of having a diversified portfolio. This comes down to how an investor establishes an asset allocation. However, asset location can be just as an important factor as asset allocation. I am not talking about having assets offshore vs. in a domestic account, but what should be owned in a tax-deferred account vs. a normal, after-tax account. Michael Kitces has done some great work in this area and a more detailed description than what I am offering in this post can be found here. https://www.kitces.com/blog/asset-location-the-new-wealth-management-value-add-for-optimal-portfolio-design/. If you want more detail, come to my office and check out Investment Management for Taxable Private Investors, published by the CFA Institute.
Achieving returns above the return of an index is called investment alpha, while being smart about asset location and reaping the tax efficiency rewards of this strategy is called tax alpha. While investment alpha can be a taunting and cruel mistress, tax alpha can be a little easier to achieve. While we have preached this for years here at WMA, I decided to put the idea into the blog after seeing a recent article on CNN Money. The article had the misleading title, Apple stock is making regular Americans rich, although no person profiled in the article had sufficient shares to qualify them as "rich". However, a couple of people profiled in the article had Apple stock in their retirement accounts. Typically, a tax-deferred account such as an IRA is not the preferred location for an individual stock. This is because if it doubles or triples on you, any sale and subsequent withdrawal of such gains are taxed as ordinary income. If the stock goes to zero, the loss is not deductible. If held in an after-tax account, however, the gains are taxed at capital gains tax rates, which are typically lower than ordinary income tax rates. In some cases, the capital gains tax rate is zero. You could also gift the shares to a charity and take a deduction at market value. You could also never sell the shares and your heirs could inherit the stock with a stepped-up basis and avoid taxes entirely. We have many clients who have held stocks for a long period of time and have achieved multiples of 10, 20 or even 50 times their original investment. Again, the potential of a zero tax rate exists. Your children or grandchildren will thank you.
The question is then what do we own and where do we own it? Most fixed-income securities, whether they are mutual funds, ETFs or individual bonds, belong in tax-deferred accounts. Municipal bonds would be the exception to this as their income is generally tax-free. Additionally, many actively-managed mutual funds, REITs and hedge funds would also go into a tax-deferred account due to turnover which would result in short-term capital gain distributions, or high income distributions. Individual stocks, equity index funds or equity ETFs would typically go into an after-tax account. The investor can exercise more control over gains and losses with these assets, as well as make use of losses which can be carried forward if they exceed gains.
The discussion of asset location assumes that you have both tax-deferred (IRA or 401(k)) and after-tax assets (including Roth accounts). If you do not, you should (I insist on this point, actually), and we will address that issue in a later post.