Jul 13

Increasing Portfolio Returns Through Asset Location Strategies

by Rockbridge Team

Ben Franklin once wrote “nothing in this world is certain except death and taxes” and as wealth managers we must help our clients manage investments in light of these certainties. Neither can be avoided, but steps can be taken to help minimize their effect on wealth levels. One way is through the use of asset location strategies.

Asset location strategies involve the use of tax-advantaged accounts (think IRA, Roth IRA, 401(k), 403(b) etc.). These types of accounts can help reduce the “tax drag” of the overall portfolio, without sacrificing proper asset allocation. This is possible because the Internal Revenue Service (IRS) taxes returns of assets differently, and investment assets exhibit dissimilar tax efficiency characteristics.

Stocks and stock funds are generally taxed as a result of capital gains when sold. These capital gain rates are usually preferential when compared to ordinary income tax rates. Dividends from stocks are also taxable, but often receive the same preferential tax treatment as capital gains. Because of lower tax rates and the ability to defer taxes (when they are not sold), most stocks are considered “efficient” from a tax perspective.

On the other hand, bonds and bond funds are primarily taxed as a result of interest payments. These payments typically cannot be deferred and are taxed at ordinary income rates. Municipal bonds can be used to avoid much of this tax burden, but expected returns (even on an after-tax basis) are often lower. As a result, most bonds (other than municipal bonds) are considered “tax-inefficient.”

Take the following hypothetical example: An investor (30% ordinary income tax rate and 15% capital gains rate) has a $1 million brokerage and a $1 million IRA account ($2 million combined). With a targeted 50/50 overall stock/bond allocation, there are two extreme scenarios of how stocks and bonds may be allocated. (Pretend there is 10% capital appreciation in stocks and 10% interest in bonds after one year).

Scenario #1Implement the 50/50 allocation with all stocks in the IRA and all bonds in the brokerage:

After one year the tax could be as follows:

  1. No taxes on the stocks inside the IRA
  2. Bonds would have $30k tax bill ($1mm x 10% interest x 30% income rate)

 Total tax = $30k

Scenario #2Implement the 50/50 allocation with all bonds in the IRA and all stocks in the brokerage:

After one year the tax could be as follows:

  1. No taxes on the bonds inside the IRA
  2. Stocks could have a $15k tax bill ($1mm x 10% gains x 15% capital gains rate)

 Total tax = $15k (but possibly $0 if the stocks are not sold and gains aren’t realized)

Another consideration is when the market goes down, there can be an opportunity for tax-loss harvesting for assets in taxable accounts. This is an opportunity not available inside of IRAs.

Since stocks are historically more volatile than bonds, it makes sense to have them in taxable accounts.

The simplistic example above should help illustrate why the asset allocations inside of different accounts may not match one another. Instead, when appropriate, we overweight tax-inefficient assets (taxable fixed income, REITs) inside of tax-advantaged accounts to increase the expected after-tax return of the overall portfolio.

The other certainty that Ben Franklin cited is death. Because the IRS also allows a step-up in basis upon death of an investor, the tax liability associated with capital gains may be avoided entirely. For example, if an investor owns a stock with a value of $100,000 (originally bought for $1,000) and dies with the stock in their taxable account, their heirs may never have to pay taxes on the stock appreciation. This is because the IRS allows for the cost basis to be stepped up to current valuation levels and capital gains taxes are never collected. This is an additional reason why it may be advantageous to have appreciable assets inside of taxable accounts and avoid having all your account allocations the same.

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