Probably most people have heard of asset allocation. In case you have not, here is the definition.
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals, and investment time frame.
Risk and reward generally go hand in hand. The idea behind asset allocation is to balance volatility in a portfolio with expected returns and a person’s financial goals. If you were to only focus on returns, you would probably have a portfolio entirely consisting of stocks as that has been the asset class that has generally had the highest returns over time.
The problem with this is a lot of people can’t handle the volatility of a portfolio with only stocks and will get nervous and sell at the wrong time. When you add other asset classes such as bonds and cash, you can dampen the volatility while still providing enough return for people to meet their financial goals. Portfolio managers can use these three variables, risk tolerance, a person’s financial goals and their investment time frame to build a portfolio that has a good chance of meeting the person’s needs.
While asset allocation is very well known and is used extensively, there is another concept that is not as well known but could be even more important.
What is Asset Location
Here is the definition. Asset Location means placement of an investment in a taxable or tax-advantaged account in the manner that receives the best tax treatment. Asset allocation refers to the way assets are mixed and portioned in each account. The choice of investment placement can have a major impact on an investor’s taxes and net after tax return.
Okay Kevin. What does this mean in English? Usually with investment accounts there are three main tax treatments of the accounts. Taxable accounts, tax deferred accounts and tax-free accounts. Here’s a quick breakdown of each of these types of accounts.
Taxable in the name means any increase in value or income that you receive from the investment will be taxed in the year you experience them. If you were to sell a stock in a taxable account, you will be taxed on the gain. It might be taxed as ordinary income, or it could be taxed at capital gain rates. In addition to this if you were to receive income or dividends from your investment, that too will be taxed.
This post is not about the various tax rates in a taxable account. I just want you to know that in a taxable account, you will be responsible for paying taxes every year depending on what happens in the account.
There are several reasons for wanting to have a taxable account. You have liquidity. There aren’t rules or penalties for taking distributions from a taxable account. In addition to that, there aren’t any limits on the amount of money you can contribute to a taxable account. Another advantage to a taxable account is you don’t have to take any Required Minimum Distributions like you have to with qualified accounts like IRAs and 401(k) plans.
Tax Advantaged Accounts
Earlier I had spoken about tax deferred and tax-free accounts. For our discussion of asset location, let’s refer to these as tax advantaged accounts. Unlike taxable accounts, with tax advantaged accounts, you don’t have to pay taxes on any income or gains in the account until you are required to take distributions. This could occur if you were to make a premature distribution prior to age 59 ½, you retired and started taking distributions or you waited until age 72 when you are required to take minimum distributions from your account whether you need the money or not.
Examples of tax advantaged accounts include IRAs, Roth IRAs, employer sponsored retirement plans such as 401(k) plans, profit sharing plans and education savings plans like 529 plans and Coverdell education savings accounts. Each of these different accounts offers some form of tax advantage. On some of them, you can make an income tax deductible contribution to your account. On others, they offer tax free growth and tax-free distributions. In general, the tax advantaged accounts used for saving for the cost of college offer some form of tax deferral on the growth of the account and tax-free distributions if they are used to pay for the cost of a college education.
While that sounds amazing, all of the tax advantaged accounts either have limits on the amounts you can contribute to the accounts, penalties for early withdrawal or some combination of these two things. In addition, some of the accounts require you to take out a minimum distribution when you reach a certain age.
Tax diversification is the strategic allocation of assets among various accounts with varying taxation. This is a nice way to say, don’t put all of your eggs in the same tax basket. With Asset Location you might want to put investments that generate income or capital gains in a tax deferred or tax-free account. For instance, you might want to put your fixed income or bond investments in your 401k plan while you keep your stocks in a taxable account.
When you allocate your investments with asset allocation, asset location as well as tax diversification you are giving yourself opportunities in the future. Let’s say you have a 401k plan, and you have some of your assets in the Roth account and some in the tax-deferred or traditional account. You are past the age of 59 ½ and you go to the Ford dealership and see the F-150 Raptor that you have always wanted, and the price is $75,000. You can take $75,000 out of the Roth account, income tax free, and buy the truck. Or you can take the $75,000 plus the ordinary income tax out of your account. Depending on your tax bracket you might have to take out close to $100,000 to net the $75,000 needed to buy the truck. In this example you can see why tax diversification makes sense.
Whenever I write these blog posts I try to make the topic broad enough that it applies to a lot of the people I deal with in my financial planning practice. But the reality is everybody’s situation is different and I work with individuals and families with their own unique situations and issues. If you would like to speak with me about your individual situation, feel free to reach out to me HERE. As always, thanks for reading. KB