Everyone wants to have the right investments. We read and listen to stock market reports, we ask friends, we even give people money to tell us how to invest money. For many, the “how” of investing — or “asset allocation” — is the beginning and end, and with good reason. How you invest is the largest determining factor in the level of returns you will see.
But what about the “where” of investing? Yes, the “how” dictates the amount of money your investment will earn. Yet, all too often, the “where” decides the potential your investment will reach and how much of that money you will actually get back after taxes.
“Not taking asset location into account can result in poor portfolio performance and a significant tax hit when investors relocate assets.”
Investing in accounts that afford the most growth after tax and get the fewest tax hits possible is a concept known as asset location (a.k.a. tax location). You can earn significant benefits by simply paying attention to the types of accounts you put certain asset classes in when you invest. Unfortunately, many of the portfolios we see don’t take asset location into account. The result is not only an underperforming portfolio, but also a significant tax hit when investors try to relocate their assets. It pays to take asset location into account at the beginning.
As with all things investing, there is no one-size-fits-all solution. So how do you determine the correct approach to asset location for you? The two biggest factors to consider are:
- the distributions coming out of the investment, and
- the potential growth from the investment.
By taking these two factors into account, you can determine how to allocate your portfolio between tax-deferred and tax-exempt accounts with relative ease.
If an asset class traditionally has high distributions, you will probably want to put that in a tax-deferred account, such as a traditional IRA or 401(k). “Tax-deferred” means your money is working for you tax-free as long as it’s in the account. This helps you avoid paying taxes on those distributions in the current year so you can keep that money invested and working for you.
TAX EXEMPT ACCOUNTS
If an asset class traditionally has higher expected returns, you will probably want to put it in a tax exempt account, such as a Roth IRA. This will help you avoid the sting of capital gains taxes (or ordinary income taxes in the future if you were to have it in a tax-deferred account) and get the full benefit of that growth.
It’s a balancing act, but a good rule of thumb is that you want your low return/high distributions asset classes (e.g. bonds) in tax-deferred accounts, and your high expected return asset classes (REITs, small company stocks, commodities, etc…) in tax exempt accounts, especially if they also have high levels of distributions. There are other considerations — such as the foreign tax credit, or how to set up an order of priority for what to put where — but getting the basics down will treat you pretty well. In investments, you get the most benefits by being mostly right.
As I said before, asset allocation is king. Asset allocation should drive asset location and not the other way around. If you have certain asset classes in the wrong account, it’s not the end of the world. But it’s not okay to leave out an asset class because you can’t put it in the right account. Where you invest is simply a strategy to make the most of what you have — the “where” should never determine the “how.”
Many people have tried to quantify the impact of asset location, but it is quite difficult. Everyone’s situation is different. If you only have tax-deferred accounts, your decision will look very different from that of someone with money all over the place. That being said, asset location can have a lasting impact on your portfolio — just make sure you take care of it when you first invest rather than trying to fix it later.
McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.
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