Asset Location Can boost After-Tax Returns
By: Warren F. McIntyre,
Re-printed with Permission
Many investors are familiar withthe concept of asset allocation as a way of diversifying a portfolio to protectit in various types of markets and economic conditions. But a new term called asset locationhas emerged which should play an important part in the design of yourportfolio.
Asset location refers to decidingwhich funds should be placed in taxable versus tax deferred accounts. Under the 2003 tax law, interest incomeand certain other investment income is taxed at ordinary rates which can be ashigh as 35%, while capital gains are taxed at a maximum of 15% and qualifyingdividends are now just 15%. Evenpeople in middle-income tax brackets might benefit from the preferentialtreatment for dividends and capital gains.
Since taxes reduce the net returnthat an investor receives, optimal location can make the portfolio more taxefficient and thereby boost the after-tax investment return.
Previously, stock funds wererecommended for tax deferred accounts, while income based investments would gomainly in taxable accounts. There were several reasons for this; including the fact that income atretirement would normally come first from the taxable accounts. This would be the preferred approach iftaxes were not a consideration, but the tax rate reductions for capital gains anddividends potentially change the equation today.
The tax law now suggests a shiftof income investments, such as bonds, into retirement accounts to the extentpractical. The taxable accountsshould now have a greater growth emphasis, especially for people who don't needmuch investment income. Theoverall asset allocation for an individual would not change; therefore, anyshift between types of accounts would necessitate a compensating adjustment inanother account.
Some general rules for placementwithin accounts are as follows:
High return, highly tax efficient assetsshould go in taxable accounts. These would include stock index funds and tax-managed stock funds.
High return, less tax efficient assets,such as real estate and high-yield bond funds and many managed stock funds wouldgo into the IRA or employer retirement account.
Low return assets can go in eithertaxable or tax deferred accounts. Thus, even though investments such as U.S. treasury bonds and short-termbond funds are taxed at ordinary rates and are not very tax efficient, theyprovide a relatively low return so it doesn't matter too much where they areplaced.
Despite the potential tax savingsfrom optimal asset location, it's generally not a good idea to overload any onearea. The future is uncertain andtax laws seem to change with the political wind, so it is important to beflexible with your investment plan.
Of course, asset location does not apply toinvestors who either have all of their investments in tax deferred accounts orall of their money in taxable accounts. But if you do have a choice - asset location should play a significantrole in developing and maintaining a tax efficient portfolio.