ASSET ALLOCATION VS ASSET LOCATION
WHAT IS ASSET ALLOCATION?
If you are an experienced investor, this is likely not a new concept for you. If you are already familiar with the idea, feel free to skip down to the next section. If you are new to investing this is where we need to start.
At a very high-level asset allocation generally starts with what percentage of your investments are in stocks vs bonds. This is the classic balance between high risk, and low risk investments. If you have ever opened an account with a financial advisor, you likely went through some sort of risk tolerance process. The point of that exercise is to give the advisor an idea of how comfortable you are with market risk. The advisor was also probably gathering some basic information like your age, and your financial goals to get an idea of your investing time horizon. Those two variables, risk tolerance and time horizon are what help that advisor determine what percentages of stocks and bonds would be a good fit for you.
Asset allocation usually goes at least one step further (unless your advisor isn’t doing their job) and looks inside of those two basic categories at more specific categories. These categories within stocks may include large cap, mid cap, small cap, international, and emerging markets. While in the bonds section you may see categories like, short term, intermediate term, high yield, and foreign. All of those (and more) categories are blended to create a portfolio for you.
The best way to visualize this process is to think of your portfolio like a pie chart. The process starts by dividing the pie into two sections. Bonds and stocks. Then each of those sections is further divided into subcategories. Ultimately your pie likely has between 8 and 15 slices, that all blend together to create a portfolio that matches your goals and risk tolerance.
The reason asset allocation matters is it actually is a large determiner of your performance. In general, the more of your pie that is stock, the higher your return. The more of your stock is small and mid-cap, the higher your return will be etc. Now, all those higher returns come with the tradeoff of more risk involved, but the idea is that by controlling those percentages, you can have a large impact on your return.
WHAT IS ASSET LOCATION ALL ABOUT?
If it weren’t for the IRS, we would not be having this conversation. You see, the difference between asset ALlocation and asset LOcation is all about the taxes. Having the right kinds of investments in the right kinds of accounts can make a pretty large impact on your overall performance. Before I can dive into how this process works, we need to have a good understanding of the types of investment accounts, and how they are taxed.
TRADITIONAL IRA ACCOUNTS
These are the original retirement account sanctioned by the IRS. They work similarly to a 401k account in that money goes into the accounts PRE-tax. That means if you contribute to one of these accounts you will earn yourself a tax deduction in the current year. These accounts grow on a tax deferred basis, with no capital gains. Eventually you will end up paying income tax when you start withdrawing money in retirement. The key thing to remember with traditional IRA’s is that you pay tax later, after your money has time to grow.
ROTH IRA ACCOUNTS
Roth IRA’s are kind of the inverse of a traditional IRA. The money you put into the account after tax money, meaning you already paid income tax on it, and you will NOT get a tax deduction right now. The big benefit to the Roth IRA however, is that the money grows tax free. That means that the money you put in today can grow and grow and grow, and you will NEVER pay taxes on it again.
TAXABLE BROKERAGE ACCOUNTS
These accounts are the unsung heroes of the investment world – if managed properly -. These accounts are not specific retirement accounts, and they get no special tax treatment from the government. Any investments in this account start building up capital gains the moment you buy them. The good news is that you do have a good amount of control over when you pay your taxes in these accounts, as no taxes are due until investments are sold. The way these operate is like many other assets (like houses). The difference between what you sell an investment for, and what you buy it for, is known as a capital gain. When you sell the investment, you officially recognize that capital gain and the government taxes the gain at a rate determined by your income.
There are two important strategies to know about when investing in a taxable brokerage account. Municipal bonds, and tax loss harvesting. For the purpose of this article, we will focus on municipal bonds. Tax loss harvesting is an in depth enough concept that it will need its own post.
Municipal bonds are just like regular bonds with one key difference. They are still debt instruments that pay regular interest payments, and they still offer a lower risk and lower return profile than stock investments. The key with municipal bonds, s that the interest they pay, is not subject to federal taxes. AND if you purchase bonds from your home state (or if you live in a state without state income tax) they also will not be subject to state taxes. That means potentially that the interest payments from municipal bonds is completely tax free.
NOW BACK TO ASSET LOCATION
To help this concept make sense consider the following hypothetical investor. Let’s call her Hannah. Hannah is a 55 yar old single woman who wants to retire in five years. Hannah has recently visited with a financial advisor and gone through a risk tolerance assessment that determined she has a high risk tolerance. Armed with that information the advisor has recommended Hannah has the following asset allocation
35% bonds
25% Large Cap Stock
15% Mid Cap Stock
5% Small Cap Stock
20% international Stock.
Hannah has done a good job of saving and has accumulated $300,000 in savings in the following accounts. (I’m glad she did because it makes the math a lot easier to follow.)
$100,000 in a traditional IRA
$100,000 in a Roth IRA
$100,000 in a taxable brokerage account
I have been doing this job for a long time, and I have seen a lot of investors like Hannah. I have seen a lot of statements from people just like her and all too often I see the same problem. The advisor they are working with has not paid any attention to asset location. It is very easy to pick out when an advisor has forgotten asset location because what I see is that all of the accounts have the exact same asset allocation. Meaning Hannah’s accounts would all look like this;
$35,000 bonds
$25,000 Large Cap Stock
$15,000 Mid Cap Stock
$5,000 Small Cap Stock
$20,000 International Stock
Initially this might not look like a problem. And to be fair, this is not the worst way she could be invested. BUT, she is leaving money on the table because her advisor never thought to consider the location of the assets. Let’s remember two things we discussed earlier. The more stock an account has, the more we expect it to grow. And, each account is taxed in a different way.
If we look at Hannah’s account in a different way, we could say she has $300,000 total. That $300,000 should be allocated as follows;
$105,000 Bonds
$75,000 Large Cap Stocks
$45,000 Mid Cap Stock
$15,000 Small Cap Stock
$60,000 International Stock
This is where asset location starts to make a huge difference. Remember how Roth IRA’s are tax free forever? Since Hannah has a Roth IRA worth $100,000 that is tax free forever, wouldn’t it make sense that we fill that account with the investments that we expect to have the most growth? So rather than having all of her account shave the same asset allocation what if we filled her Roth IRA with the highest risk, highest return investments ad made it look like this;
$45,000 Mid Cap Stock
$15,000 Small Cap Stock
$40,000 International Stock
That account by itself is probably too risky for Hannah, but remember we are looking at her whole picture, not just her Roth IRA. She also has $100,000 in a taxable brokerage account we need to address.
Overall, Hannah needs about $100,000 in bonds. Remember those tax-free municipal bonds? What if we decided to fill her taxable account completely full with $100,000 of municipal bonds? That would do two things for us. First, it would almost completely satisfy her overall need for bonds ($105,000), and secondly, due to the tax-free nature of the bonds, we just turned her taxable brokerage account into a tax free account.
What that leaves is $100,000 in a traditional IRA that can now be allocated almost entirely to stocks, and earn more growth than it would have if it included 35% bonds like her overall profile suggests.
By following through with those ideas we would create three accounts that looked like this
Hannah still has $300,000. Each account still has $100,000 in it. Overall, Hannah’s allocation has not changed and still has;
$105,000 Bonds
$75,000 Large Cap Stocks
$45,000 Mid Cap Stock
$15,000 Small Cap Stock
$60,000 International Stock
The only thing we changed was the LOCATION of the assets. By being cognizant of which accounts held which investments we were able to get her
More tax-free growth
More tax-free income
More tax deferred growth
All without changing her risk tolerance, goals, or overall asset allocation. In short by using asset LOCATION techniques in addition to asset allocation we were able to improve her after tax return significantly.
WHY ISN’T MORE ATTENTION PAID TO LOCATION
I wish I had a great answer to that question. The cynical side of me says that it’s simply because most advisors don’t want to do the extra legwork required to set up the accounts. It’s easier to manage three accounts that are the same.
The realist in me thinks that it is sadly because many advisors are unaware of the power of asset location. Advisors are an interesting bunch. Many are consumed by trying to squeeze every penny of investment performance out of a portfolio. That is a very noble goal. But becoming too consumed by performance can cause advisors to blind themselves to the bigger picture. A picture that is largely controlled by the IRS. Many advisors are also part of large firms who strictly forbid them from giving tax advice. To be clear, I don’t think anything I have written here suffices as tax advice. Tax strategies, yes. Tax planning, yes. But not advice. But, because this deals with taxes many advisors simply steer clear of it.
If you work with an advisor who never talks about taxes you need to think about some things. Every move your advisor makes, comes with tax implications. Sell a stock. Contribute to an IRA. Take a withdrawal from your 401k. All create tax issues. You need to be working with an advisor who is not burying their head in the sand when it comes to taxes. You need someone who will help you plan for those issues.