With Tax Strategy, It’s Asset Location, Not Allocation That Counts

By Brian O'Connell

With new tax policy getting a green light from Congress, investment professionals are already scrambling to gauge the impact on client investment portfolios.

One move that financial specialists are already making is to hit the tax sweet spot between what one financial advisor calls asset allocation and asset location.

“It’s the often-overlooked strategy of placing investments in the right accounts to minimize taxes,” said Thomas Walsh, a money manager with Palisades Hudson Financial Group, in Atlanta.
The difference between asset allocation and asset location is all about stashing tax-efficient investments in taxable accounts and steering tax inefficient investments in tax-free or tax-deferred accounts, and doing so in a portfolio unified manner, Walsh said. “By considering all of your accounts together,” he said, “you can make good decisions about which accounts will hold which types of assets.”

Analyzing the tax implications of asset allocation shouldn’t be the byproduct of new legislation from Washington, D.C., even though that’s the case in late 2017, said Michael Shea, a financial advisor at Applied Capital in Nashville.

“Regardless of what is going on with tax reform, when analyzing your portfolio, tax considerations should always be taken into account,” Shea said. “The more money you earn, the more important it is to be aware of the tax implications of your investments and what accounts they’re held in.”

For example, if you have client retirement accounts such as 401(k)s and IRAs in conjunction with after-tax brokerage accounts, you should pay attention to what positions are in each account. “If you have a high-income-producing asset like real estate or fixed income you’re usually better off having this in a qualified account,” Shea said. “This way you don’t have to pay taxes on the income.”

Money managers also need to pay attention capital gains distributions in their mutual funds. “These distributions can occur when securities inside a mutual fund have been sold to raise cash,” Shea said. “This could happen due to investors selling their positions. In 2008 and 2009 this was an issue for some people because investors were fearful and wanted to get out of the market. This triggered out flows from mutual funds. As a result, those who stayed invested got hit with a larger tax bill due to capital gains distributions that were passed on to shareholders.”

Stock and Fund Tax Location Strategies

Where to put the appropriate investments, tax-wise? Investment experts say the answer isn’t a complicated one.

“The key to asset location is to place the most tax efficient assets into taxable investment accounts and the most tax inefficient assets into the tax-deferred/Roth accounts, said Ben Westerman, senior vice president at HM Capital Management, in St. Louis, Mo.
“Index funds (in particular the S&P 500 Index) are the most tax efficient investment vehicles,” Westerman said. “These investments should be held in taxable accounts. Less tax efficient equity investments, such as actively traded funds, should usually be held in tax-deferred/Roth accounts.”

“Meanwhile, bond investments, due to the potential for ordinary income from interest payments and any investments in commodities, should be held in tax-deferred accounts,” Westerman added.

There are some more specific tips on where to put stocks and funds, to gain those big tax advantages, according to Westerman.

For stocks - Investment advisors should aim to put client stocks in your taxable accounts because the income on stocks (i.e. dividends) are generally taxed at preferential tax rates, said Derek Hagen, director of wealth management at Flourish Wealth Management, in Edina, Minn. “Further, you have some control over the capital gains, because you'll only pay those if you sell your investments at a gain. Long term capital gains are taxed at preferential rates, as well. Short term capital gains, though, are taxed at ordinary income tax rates.”

For funds - If money managers are investing client cash in funds, the goal is to look for funds with low turnover ratios for your taxable accounts, Hagen said. “This ratio indicates how much the fund company trades,” he explained. “The more they trade, the more likely it is that you will get capital gains distributions, even short term capital gains distributions.”

Additionally, a money manager’s best bet is to look for funds that are tax-managed, said Hagen.

“Broad funds are usually better than specific funds,” he said. “If a small company does well, for example, a small cap manager will have to sell it from her fund since it is no longer a small company. This could result in capital gains distributions. That same company in a broad market fund won't have to get sold.”

No “One Size Fits All”

By and large, asset allocation is no “one size fits all” process. Factors like current and future tax estimates, investment account types and sizes, and even estate planning issues factor into the equation.

“It’s as much an art as it is a science, and sometimes you have to make compromises with what’s ideal versus what’s practical,” Walsh said. “While asset location may not save you a large amount of taxes in any one year, it should produce small increases in your after-tax return every year. Over decades, these small amounts compound and can really add up. There’s no need to pay more federal and state income taxes than you have to.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at [email protected].