Location, Location, Location!

By: Michael Foster, CFA, CFP®

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What comes to mind when you relate location to your vocation? This is an easy question if you’re a realtor, travel planner, hotel operator, or similar. It may get a little more convoluted once leaving the “spot on the map” meaning. For instance, if you’re a physician, it could be discovering where treatment is needed for a patient. If you’re in marketing, it could be how you describe your target demographic or customer segment. If you’re Greg Maddux, it could be planning the next pitch to the hitter’s weak spot. If you’re a writer or English teacher, it could be reviewing this blog and pointing out where punctuation errors occur while cringing at the corny rhyme in the first sentence. Location means different things to different people!

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When it comes to investing, location, specifically asset location, has its own meaning. 

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Many people are familiar with the concept of asset allocation - diversifying investments across different asset classes like stocks, bonds, and real estate, among others. However, another crucial aspect that often gets overlooked is asset location. Asset location is the strategic placement of assets in various types of accounts (e.g., taxable, tax-deferred, and tax-free) to maximize after-tax returns. Of course, the asset location strategy used needs to consider your financial goals, risk tolerance, and current asset levels across account types, among other things. Do all your accounts hold the same investments in the same weights? If so, you may want to consider the potential benefits of optimizing asset location. 

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Tax Efficiency

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One of the easiest to digest benefits of asset location is a focus on tax efficiency. Different types of accounts and different types of investments have different taxation consequences. If you can place assets in the appropriate accounts, you can hopefully reduce future tax liability and allow your investments to grow further over time. 

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• Taxable Accounts - It can often make sense to hold equities in taxable accounts. We typically invest in stocks through low-cost, diversified, tax-efficient ETFs and funds for our clients. If held for the long-term, these assets are subject to capital gains tax rates, which are typically lower than ordinary income tax rates. 
• Tax-Deferred Accounts - Traditional IRAs, 401(k)s, and other tax-deferred accounts allow investments to grow tax-deferred until withdrawal. This can be beneficial for assets that generate high taxable income, such as bonds or real estate, both of which distribute income taxed at ordinary income rates.
• Tax-Free Accounts - Roth IRAs and Roth 401(k)s are taxed in the current year and then offer tax-free growth and withdrawals for qualified distributions. Investments with high growth potential, like equities or real estate can be ideal for these accounts. Real estate can make sense in particular given income distributions taxed at ordinary income rates.

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Flexibility & Protection from the Unknown

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Having assets across the 3 tax “buckets” can provide many withdrawal options when the funds are needed in the future. The taxation of withdrawals is different by account, and if done strategically, those withdrawing funds can manage their tax liabilities, potentially lowering the overall tax impact. For instance, you can potentially have lower taxes in the earlier years of retirement (sixties and early seventies) by withdrawing from your taxable accounts at capital gains rates or tax-free accounts prior to your required minimum distributions (RMDs) beginning from your deferred accounts. 

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Asset location also can protect some assets from changes in future tax rates. By paying a known tax rate today, you can avoid potential increases in tax rates you might be delaying. Of course, this can work against you as well should tax rates be lower in the future. This strategy can be personalized by the individual or family based on their tax situation and goals.

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All in all, asset location can be a powerful strategy that, along with a sound asset allocation and investment choices, can help you better achieve your financial goals. By optimizing the holdings and use of taxable, tax-deferred, and tax-free accounts, investors can hopefully maximize tax efficiency and flexibility while hedging their situation from future tax rates.