Strategic Asset Location - A Tax-Smart Strategy For Portfolio Construction

What is asset location and their advantages in portfolio construction?

Welcome, everyone. My name is Tan and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner.
In this video, I want to talk to you about asset location.

What is asset location?
Asset location is determining which types of investments should be in which types of accounts.

Why?
- Different accounts, such as Individual Retirement Accounts, 401(k)s, 403(b)s, 457(b)s, brokerage accounts, and trusts, have different rules and features.
- They have their advantages and disadvantages.
- Also, all investment gains are not taxed the same.
- They can be taxed at ordinary income tax rates, capital gains rates, and/or be tax-free.

So why does this matter to you?
- Asset location lets you take advantage of the different account types to maximize tax-efficiency. Which means, asset location could assist you with getting a higher after-tax return for a similar level of risk.
- Please note that asset location is different from asset allocation.
- Asset location is determining which assets will go where to maximize after-tax return and asset allocation is the types of assets you own, like how much you should be in the United States, how much you should be in international and emerging markets, etc.

Let me explain asset location in more detail and provide more examples.

Tax-inefficient investments in tax-advantaged accounts:
- Tax-advantaged accounts are composed of two types of accounts:
- Tax-deferral accounts and tax-free accounts.
- Tax-deferral accounts where the gains are deferred and taxes are paid in the future.
- These are your Traditional IRAs, 401(k)s, 403(b)s, 457(b)s, and tax-sheltered annuities. They are taxed at ordinary income tax rates.
- Tax-free accounts are accounts where you pay no tax at withdrawals if done correctly. These are your Roth IRAs and Roth 401(k)s.
- Tax-inefficient investments are dividends paying stocks, corporate bonds, taxable bonds funds, actively managed mutual funds, mutual funds with high turnover, real estate investment trusts (REITs). Investments that generate incomes and subject to taxation.
- You put those in there.

Why?
- For example, bonds coupons are taxed at ordinary income tax rates.
- If you put bonds in tax-advantaged accounts when you get coupon payments from the bonds, you don’t get taxed because it’s in tax-advantaged accounts.
- You control when you want to get taxed or not taxed at all and that is the beauty of asset location.

Tax-efficient investments in taxable accounts:
- Taxable accounts are brokerage accounts and trusts.
- They are taxed at capital gains rates or ordinary income tax rates depending on the holding period and account types.
- Tax-efficient investments are total stock market index funds, board market ETFs, broad market equity funds, growth individual stocks, municipal bonds, municipal bonds funds, tax-managed funds.
- They are highly taxed efficient.
- You put those in there.

I like to put assets that have a high potential for growth and least tax-efficient in tax-free accounts. Examples are small caps, emerging markets, international, and value stocks in Roth IRAs and Roth 401(k)s.

For the tax-deferred accounts, like 401(k)s, 403(b)s, 457(b)s, and tax-sheltered annuities, I like to put real estate investment trusts and bond funds because if they were held in taxable accounts, they could be taxed at ordinary income tax rates.

For the taxable accounts, the assets varies because it depends if I am constructing a portfolio for a high-income earner, a retiree, or an investor who wants to fund a goal.

Asset location is not set in stone. It could change based on changes in tax rules and your unique circumstances. It is best to talk to a professional before making an investment decision.

Here is the caveat, asset location does not take into consideration liquidity and the need for income. What I mean by this is, let’s say for a retiree, they need to generate income from their bonds fund to live. If all of their bond funds are in a 401(k), all of that income will be taxed at the ordinary income tax rates to them.

If they can have some income comes out of the 401(k) and the remaining money comes out of their Roth IRA, they will pay less in taxes because Roth IRA distribution is tax-free as long as you follow the rules.

Here are some questions to ask yourself to assist you in determining which assets should go where:
1. Do I have carryover losses? The rationale behind this question is if you have carryover losses, you could offset the losses with investments gains.
2. Am I maxing out all of my tax-advantaged accounts?
3. What is the purpose of the money?
4. What is my expected return on the investments? It is like having a cash position in a taxable account versus a cash position in a 401(k). There is no advantage for asset location.

The higher the expected return on the investments, the greater the benefit from tax-advantaged accounts. Portfolio construction is an art.

Here are best practices:
1. Set your goals.
2. Set your account types.
3. Set your asset allocation.
4. Set your asset location.

Don’t let the asset location be the primary component in making investment decisions. Asset location should compliment with your asset allocation and goals, so you can be a tax-smart and tax-efficient investor.

To summarize, you want the least tax-efficient and high expected return investments in tax-advantaged accounts and you want your most tax-efficient investments in taxable accounts.

It’s not what you make, it’s what you keep that matters.
Thank you for watching.
This is Tan, your trusted advisor.

This material is for educational use only and does not constitute tax, legal, or investment advice. Information may be changed or updated without notice. Consult with a licensed professional regarding your personal circumstances.

Please do not excerpt or copy this information without prior consent from TAN Wealth Management.