Location, location, location: But when it comes to assets, don’t ignore allocation
Many people focus on asset allocation with their investments but forget asset location.
While they might sound similar, they serve distinct purposes for a well-rounded investment and tax planning strategy.
Asset allocation is the process of dividing your investment portfolio among different asset classes, such as domestic stocks, international stocks, bonds, cash and alternatives.
Asset allocation key factors
Risk tolerance: Risk tolerance is different for everyone and different asset classes come with varying levels of risk. For instance, all the stock asset classes generally offer higher potential returns but with higher volatility. Bonds and cash tend to be more stable but offer lower returns. Spreading out your asset allocation percentages helps you manage risk according to your comfort level.
Investment horizon: If you have a long-term horizon, you might allocate more to stocks because despite their volatility they have historically provided higher returns over long periods. Conversely, if you’re closer to your financial goal, such as retirement, you might shift more toward bonds or cash to preserve your capital.
Diversification: Asset allocation inherently provides diversification. By spreading your investments across different asset classes, you avoid the potential negative impact of a single asset class performing poorly. This follows the adage of “don’t put all your eggs in one basket.”
Rebalancing: Just as your car needs regular maintenance, your portfolio needs regular maintenance, too. Rebalancing is the ongoing maintenance of your asset allocation. Over time, your portfolio’s asset allocation may drift from your target asset allocation. Regular rebalancing maintains alignment with your risk tolerance and goals.
Asset location’s key pillars
Asset location involves strategically placing investments in different types of accounts (taxable, tax-deferred and tax-free) to better position your tax efficiency.
Taxable accounts: These accounts don’t offer any tax advantages. You pay taxes on dividends, interest and realized capital gains. Therefore, we believe it’s generally best to hold tax-efficient investments, such as exchange traded funds, individual stocks or municipal bonds, in these accounts. These investments make the taxation easier to control and plan for.
Tax-deferred accounts: Pre-tax accounts such as 401(k)s and traditional IRAs allow you to defer taxes until withdrawal. This makes them ideal for holding assets that generate significant taxable income, such as bonds, bond funds, real estate funds, alternative investments or actively managed mutual funds. The income generated from these funds are not taxed because they are paid into a tax-deferred account.
Tax-free accounts: Roth IRAs and Health Savings Accounts (HSAs) are examples of tax-free accounts. Roth IRAs have after-tax contributions but withdrawals are tax-free if certain conditions are met. HSAs have pre-tax contributions, tax-free growth and tax-free withdrawals if certain conditions are met. These accounts are well-suited for high-growth investments like stocks and growth funds.
The goal of asset location is managing tax efficiency. Employing asset location seeks to minimize taxes and to enhance your portfolio’s after-tax returns. This allows for increased dollars in your pocket and less to Uncle Sam. For instance, placing a heavier weight of bonds in a tax-deferred account can reduce your tax liability and positioning a heavier weight of stocks in a Roth IRA allow you to benefit from tax-free growth.
How to integrate both
▪ Asset allocation and risk management: Proper asset allocation is fundamental to managing risk and aligning your portfolio with your financial goals. Without a thoughtful allocation strategy, you could miss out on diversification benefits, potential returns and appropriate level of risk.
▪ Asset location and tax efficiency: Asset location, on the other hand, is about squeezing the most value out of your investments. Through strategically positioning them in accounts that provide many favorable tax treatments you can seek to create greater after-tax returns. This approach doesn’t change your risk profile but instead helps reduce the tax drag on your investments.
▪ Integrating asset allocation and asset location together: Start with asset allocation. This builds your foundational investment strategy based on your risk tolerance. Next, apply asset location by selecting the most efficient investments for your respective account types (taxable, tax-deferred and tax-free). Lastly, regularly tweak and rebalance your accounts so you are doing the most to better position your after-tax returns.
Christian Binger is a wealth advisor with Embark Financial Partners. He is also a member of the Financial Planning Association of Greater Kansas City. Securities and advisory services offered through LPL Financial, a registered investment advisor.
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