Does Asset Location Make Sense?
I’m often asked what I think about asset location strategies. This is a tax management technique where an investor places the most tax-efficient investments in the least tax-efficient account type and vice versa to reduce near-term taxes. There are advantages and disadvantages to this strategy. I believe whether you choose to do this or not is a matter of preference rather than substance.
An example of tax location would be to put common stock index funds and exchange-traded funds in a taxable account. This is because those investments have little portfolio turnover and distribute only small capital gains annually, if any. Dividends distributions would be taxable, although at a lower rate than ordinary income.
In contrast, taxable bonds, REIT index funds and most alternative investments would go into a non-taxable account such as a Roth IRA, or a tax-deferred account such as a rollover or contributory IRA. This shields the ordinary income that’s generated by these investments from being taxed as income.
This strategy sounds correct on the surface and it’s often heralded in the media as a smart way to invest. I agree with the concept in general, but that doesn’t mean there aren’t drawbacks. Here are some of the problems I see with asset location for tax purposes:
- Tax-favored account capacity: you may not have enough room in your non-taxable or tax-deferred accounts to accommodate enough bonds to have the overall asset allocation that you desire.
- Taxable account capacity: the same limited capacity issue may occur in your taxable accounts and the amount of stocks you wish to own.
- The choice may not be yours: your employer-sponsored 401(k) may have poor bond choices and good stock fund choices, or there may not be any REITs available.
- Accounting across accounts: maintaining a portfolio to a target asset allocation becomes more difficult when you’re monitoring an allocation across several accounts rather the same allocation among accounts.
- Rebalancing across accounts: rebalancing a portfolio becomes more difficult when several adjustments need to be made across different account types. Settlement dates may be different, or you may be restricted on when you can trade one account versus another.
- Tax rates in the future cannot be known: the tax strategies we employ today tend to be focused on the situation today rather than in the future. A tax-saving strategy today might cost more in taxes than anticipated as your tax rates changes in the future.
- Liquidity becomes expensive: your situation is bound to change over the years as your life changes. There may be a time you need liquidity to buy a home or for another purpose and you find yourself selling the only thing you have in your personal account – stocks. This could mean paying a lot in capital gains taxes when you need the most liquidity.
The alternative to an asset location strategy across accounts is to hold the same asset allocation among accounts. Assuming you have one taxable and one non-taxable account of the same value, you would hold the same asset allocation in both accounts.
Holding the same allocation among accounts may not appear to be the most sensible solution in the short term, but it is easier to maintain than an asset location strategy and it might provide the best long-term tax solution if you find the need for liquidity.
Perhaps the best strategy is a little of both. I have some bonds in my taxable account and some stocks in my retirement account. The bonds in my taxable account are municipal bond funds, so this keeps my taxes low. The stocks in my retirement accounts tend to be REITs and value funds that pay higher dividends, so this helps with taxes also. In general, I’m not locked into one strategy over the other.
I believe for most people this debate is more of a talking point than a substantial decision to do one or the other. Asset location across accounts makes sense sometimes depending on the situation - but so does asset allocation among accounts. It may help to do one or the other based on your unique situation, but my hunch is that for most people the tax savings all come out in the wash over time.