Asset Location Part 1 - A Theoretical Framework
In addition to asset allocation, WHERE you place your assets makes a difference.
In my last article, I provided an update on the status of my personal portfolio as of Q2 2022.
Towards the end of that article, I offered the following teaser.
[T]here is an additional topic I did not even touch on in this article. This has to do with asset location. You see, in addition to one’s selected allocation, it is worth considering what assets belong where, both in terms of tax efficiency and potential volatility.
I plan to use the same data from which this article was generated to share my strategy with respect to this in a future article or articles.
As I worked through it, I decided to make this a two-part series of articles, I will start with a brief overview of the decision making process when it comes to asset location. Next, I will dive into the greatest level of detail I have ever shared with respect to my personal portfolio, to show how I am attempting to implement these concepts.
In this first article, I will offer a brief theoretical framework to help you with your asset location decisions. The article will by no means cover every scenario. At the same time, I hope to share enough information that you can pursue the issue with further reading, to the extent you desire to do so.
Asset Location - Accumulation Phase
In short, the decision as to asset location has everything to do with taxes.
Similar to earnings from your work—whether automatically withdrawn in the form of withholding or paid via estimated payments—earnings from your investments are taxed. The goal, then, is to invest in such a way as to (legally) minimize such taxes.
As it happens, the government has provided various tools to allow you to do so. In this brief overview, we will feature 3 categories of accounts. For purposes of our discussion, I will refer to these as follows:
Taxable accounts (TA). This refers to fully taxable investment accounts.
Tax-deferred accounts (TDA). This refers to IRA and 401(k) accounts.
Tax-exempt accounts (TEA). This refers to Roth IRAs.
Before we go further, a clarification. A Roth IRA is not truly tax-exempt, since taxes must be paid at the time contributions are made. But, during retirement, when it comes time to plan our strategy for how to withdraw these funds, those in the Roth IRA will be tax-exempt.
With that, let’s briefly discuss some key concepts. We will start with the accumulation phase, the phase of life where you are seeking to accumulate assets.
Fund deductible retirement accounts first - In general, it is preferable to fund tax-deferred and/or tax-exempt accounts before taxable accounts. These are your most tax-efficient options. To the extent you have additional funds to invest after providing for current needs as well as a “rainy-day fund” to deal with unexpected emergencies, these can be invested in taxable accounts.
Have a preference for equities in taxable accounts (TA) - In saying equities, we are distinguishing these from bonds or similar fixed-income investments. There are several reasons for this. Here are 3 key reasons:
Equities receive preferential tax treatment. If held for at least one year, they benefit from lower capital gains tax rates. In most cases, dividends also benefit from preferred tax rates. In contrast, fixed income investments are subject to ordinary tax rates, the same as wage income.
Capital gains are due only when realized. This leaves you with at least some ability to control the timing of realizing gains. In addition to individual stocks, in general ETFs also offer the same benefit. As ETF Monkey, this is one of the many reasons I hold ETFs as opposed to mutual finds in my personal portfolio.
Losses can be harvested for tax purposes. Likely, not every stock you purchase will turn out to be a winner. If you decide to sell the stock, you can realize a tax deduction for the loss. You do not have this option in a TDA or TEA. Caveat: Be aware of wash-sale rules in doing so. While a full discussion of these is beyond the scope of this article, these rules essentially prevent you from buying back the specific, or a “substantially similar,” asset for a period of 30 days.
Have a preference for holding bonds, REITS, and TIPS in tax-deferred or tax-exempt accounts (TDA & TEA) - In short, the reasons for so doing are the inverse of those featured above. In brief, income from bonds, REITS, and TIPS is generally taxed at ordinary tax rates, which tend to be much higher for most investors. In the case of TIPS, increases in principal value as a result of inflation adjustments are also taxed as income in the year they occur, even if the TIPS are not sold or mature. You may sometimes hear this referred to as “imputed income.”
Finally, while it is possible to lose money in bonds, in general they don’t tend to be as volatile as stocks, lessening the potential benefits of tax-loss harvesting.
For retirement funds (TDA & TEA), have a preference for holding your highest-growth assets in tax-exempt accounts (TEA) - In general, this would lead to a greater allocation to assets such as bonds, TIPS and REITS in TDA accounts, and higher-growth assets in TEA account. We will get into the reasons for this in the next section.
Asset Location - Retirement and Decumulation Phase
In the previous section, we discussed asset location during the accumulation phase, the phase of life where you are seeking to accumulate assets. If you do well during this period of your life, there is a happy chance that you will arrive at your retirement with a decent amount of funds at your disposal.
Let’s now talk about how this asset location can start to play out in what is referred to as the decumulation phase, when you start to draw from these assets to fund your income requirements during retirement.
In general, the accepted wisdom is to draw first from taxable accounts (TA), then tax-deferred accounts (TDA) and finally from tax-exempt accounts (TEA). Please pay attention, though, to this key concept: The name of the game is to manage your TDA to minimize the average of the marginal (highest) tax rates on such withdrawals.
Let me explain. A key concept is that you will pay the taxes due on your investments at some point. In the case of your tax-deferred accounts (TDA), you have managed to escape this until such time as you withdraw the funds. But, the time will eventually come to “pay the piper,” in one of two ways.
You need to withdraw such funds to provide for needed income.
When you reach the age where you must take required minimum distributions (RMD). Even if you don’t need the money, the IRS mandates that you withdraw, and pay taxes on, a certain percentage of your balance.
What about the other two types of account, the TA and the TEA? In short, in addition to your TDA funds, you may have funds you can draw on in your TA. In the case of the TA, the biggest challenge will be managing any unrealized capital gains. Lastly, if you contributed to a Roth IRA, since you paid any required taxes up front at the time of investment, it now functions as a tax-exempt account.
Finally, you may recall that I concluded by suggesting you place your highest-growth assets in your TEA as opposed to your TDA. In short, the reason for this is the sequence of withdrawals mentioned above. Typically, these will be withdrawn last. Further, if such high-growth assets manage to continue that trajectory, you will gain the greatest benefit, and pay the least TDA-related taxes, by doing so.
Preview Of Coming Attractions
As mentioned, the brief overview of the asset location framework is admittedly somewhat general in nature. Depending on the complexity of one’s circumstances, the services of a professional financial advisor may prove beneficial. It is often the case that such professionals have software tools that can forecast future returns and make the best possible calculations on your behalf.
In Part 2 of this series (UPDATE: see link below), I will lay out how I am attempting to implement the above principles to the best of my ability within my personal circumstances. That doesn’t necessarily imply that you should, or will, do everything exactly the same way. But hopefully, if nothing else, it will offer you a nice baseline from which to build.
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Until next time, I wish you . . .
Successful investing!!
This is a nice, easily accessible, and easily understood basic approach to managing the various types of US investment accounts available to individuals who are employees.