Asset Location: An Often-Overlooked Aspect of Investing

Throughout investing circles, you hear about the importance of asset allocation and diversification.  Asset allocation means to have a proper percentage of your invested assets spread throughout multiple investment classes (i.e. large company, small company, mid-size company, international, etc.).  Diversification is very simply the old adage your grandmother used to tell you:  Don’t put all your “eggs” in one basket!

I want to briefly discuss an often-overlooked aspect of investing, which is asset location.  This is simply the idea of “putting the right stuff in the right bucket.”  The stuff in this analogy is the different asset classes where you have your money invested and the right bucket is either a designated retirement account or a non-retirement account.  (A lot of investment professionals want to use the terms qualified account and a non-qualified account.  Keep in mind I work with normal everyday working people so I try not to speak in financial jargon that often).

First, as much as possible you want your interest-earning assets (i.e. money market accounts, CDs, bonds and bond funds) inside of your tax-deferred investment vehicles.  With most tax-deferred vehicles, you receive a tax deduction on the contribution you make.  Here are some common tax-deferred vehicles you may have available to you:  401k (403b), Traditional IRA, Series E/EE Savings Bonds.  (I did not include annuities in this explanation.  If you are really interested in why please read my previous posts on annuities.)  When you take money out of a tax-deferred investment vehicle, you have to pay ordinary income tax (the percentage of tax you pay on the last dollar of taxable income) on the distribution.  This can be as high as 35% on your federal tax return.  Depending on your state, this number could be significantly higher.

You will want to use non-retirement (or taxable) accounts for the investments of large-US companies you have in your portfolio.  Non-retirement accounts have special tax treatment under current IRS rules.  You currently will pay either 5% or 15% on long-term capital gains you have inside of these accounts.  (Actually under current rules if you are in the 15% taxable bracket your long-term capital gain rate is 0%.  With the way the stock market has been over the last year, who has capital gains right now?)

Finally, the assets that have the most potential risk/ reward benefit I recommend using in Roth IRA or Roth 401k accounts.  Remember Roth accounts grow tax-deferred and when you make a distribution you receive it tax-free.  The investments I like to see in Roth IRA/ 401k accounts are the following:  small companies, international stocks, emerging markets, etc.  The idea behind this is that you want to capture as much tax-free growth as possible and the Roth IRA/ 401k is the avenue by which to do this.

The overarching theory behind this approach is that you not only want to have proper asset allocation and diversification, but also you want to have a tax efficient portfolio.  (This is not a tax scheme it is just having your assets in the right buckets so you can benefit from current IRS rules).  “We pay fewer taxes if we put a low turnover equity portfolio in our client’s taxable account and a fixed-income portfolio in the tax-deferred account” as written by Allan Roth on page 74 in the March 2009 edition of Financial Planning.

This approach requires a “global” understanding of your own or your client’s investment portfolio.  From my experience, many investment professionals do not take this global approach.  What I mean by global is allocating your entire investment portfolio as if it is one large portfolio rather than allocating according to your risk analysis in each individual investment vehicle.  A non-global approach would take a 60% equity and 40% fixed-income investor and allocate each individual account according to this allocation.  A global approach allocates the client’s entire portfolio as 60/ 40 while keeping in mind the tax benefits/ consequences of each individual investment vehicle.

I often see where asset location is not even considered in a portfolio.  (The reasons why are for a later blog entry).  I find bond funds inside of Roth IRAs and international funds inside of Traditional IRA 401k accounts.  I believe that many investment professionals do not fully understand the tax ramifications of the investment decisions they make for their clients.  (Maybe that is why at the bottom of most registered representatives advertising pieces you will see the following statement:  please consult your tax advisor for specific tax advice.)  I think that label is like the warning label on cigarettes.  If you don’t consult your tax advisor, the investment implementation strategy your advisor gives you could be harmful to your financial health.

About the author

Kevin F. Jacobs, CFP®, EA

Kevin Jacobs, the founder of Step By Step Financial, LLC, has been a recognized CFP® practitioner since 2008 and has been in the financial services industry since 2005. As an Enrolled Agent (EA), Kevin is also licensed to practice before the IRS. Before 2005, he served as a youth director in Memphis, TN. Kevin and his wife, Donella, have seven children (5 boys and 2 girls). They are active at their church and Kevin is also very involved in the community of Broken Arrow.

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