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By Jack Kraft, CFA, Advisor Directed Portfolio Analyst

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As individuals build wealth, planning for retirement becomes more complicated with investors owning multiple account types in a single household. Many people make the mistake of choosing a similar asset allocation across these accounts, rather than taking advantage of each account’s strengths. Understanding and utilizing asset location is one way to create synergies between accounts to maximize tax efficiency and reduce risk. Asset location can be described as deciding where assets should be placed (or located) across taxable and tax-sheltered accounts.

First, let’s take a look at the three main types of investment accounts individual investors have access too – taxable, tax deferred, and tax-exempt accounts. Below we have included a snapshot table that briefly describes the characteristics of each account.

Investment Account Characteristics

Understanding which investments to place where can help increase tax efficiency across accounts in a household. To do this, an investor should place the less tax-efficient securities in tax-protected accounts. For example, an investment in a coupon paying bond would be considered a less tax-efficient investment, because distributions are taxed annually at ordinary income rates. The main benefit of locating these securities in tax advantaged accounts would be to avoid yearly tax payments, thus allowing bond coupon payments to compound tax-free until it’s time to take distributions.

On the other hand, more volatile and tax-efficient securities, such as a non-dividend paying growth stock, have the ability to reduce overall risk when held in a taxable account as compared to a tax advantaged account. The main advantage in this scenario is that when these types of securities are held in a taxable account, part of the investment risk is shared with the taxing authority (or the IRS) through tax loss harvesting. In a tax-protected account, investors assume 100% of the downside risk since tax loss harvesting cannot be utilized. If used properly, an investor can ultimately benefit from compounding in tax advantaged accounts, while also lowering the tax payable in taxable accounts through timing of capital gains and losses.

Implementing Effective Asset Location Strategy

*For illustrative purposes only. This figure acts as a guide for tax-efficiency and investors should consider other tax consequences into the asset relocation decision.

Another way asset location can be used to increase tax efficiency requires an understanding of the different types of retirement accounts. The after-tax value of a tax-exempt account and tax deferred account are dependent on two factors: the tax rate at the time of contribution and the tax rate at distribution. All else equal, a tax-exempt investment account will realize a larger after-tax return if tax rates are lower during the contribution period compared to the tax rate during withdrawals of tax deferred accounts.

In a perfect world, this would be an easy decision, However, tax rates are unlikely to remain constant amid everchanging fiscal policy. In 2020 and 2021, the U.S. government has passed three separate bills worth nearly $5 trillion to support the economy during the COVID-19 pandemic. Additional spending by the U.S. government is also being considered with an infrastructure bill being negotiated on Capitol Hill. In theory, an increase in government spending results in a wider deficit, which suggests higher tax rates in the future. Ultimately, investors should consider possible changes in future tax rates when making the asset location decision that is most suitable for them.

It is important to remember that the asset location decision is subjective, and what may be beneficial to one investor may not be to another. A good rule of thumb is that if a taxable portfolio and a tax deferred portfolio both are intended to be used for retirement, then locating assets based on taxation may be logical. Conversely, if a taxable account has a short-term time horizon, while a tax-deferred account has a longer-term time horizon it may be less appropriate to locate assets based solely on taxation. Implementing an effective asset location strategy should not change the asset allocation decision of the portfolio; rather, such planning should improve the overall structure of where assets are held. Work with your financial advisor to consider other characteristics such as behavioral constraints (passive versus active investing), tax considerations, and time horizon in order to determine a suitable strategy.

 

Benjamin F. Edwards & Co does not provide tax advice therefore it is also important to consult with your tax professional for additional guidance tailored to your specific situation.