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Asset Location Just as Important as Asset Allocation


For investors in high-tax brackets, the asset location decision can be just as important as asset allocation. Otherwise, your portfolio is exposed to significant, and unnecessary, tax liabilities.

The asset location decision can be just as important as the asset allocation decision, particularly for investors in high-tax brackets.

What is asset location? It is when the investor (having completed the portfolio design/construction) decides where to locate his or her various investments in his or her different investment accounts. These accounts might consist of taxable brokerage accounts, traditional IRAs, Roth IRAs, and variable annuities.

Many of our prospective clients have done a decent job with their overall asset allocation, but they have not really put much thought into asset location. This can result in them unwittingly exposing their investment portfolio to significant, and unnecessary, tax liabilities. To add insult to injury, this also means that when losses occur, the investor may not be able to use these losses to offset capital gains elsewhere in the portfolio.

Here are some real examples of tax inefficiency:

• High yielding, fixed-income mutual funds located in taxable accounts, when traditional IRAs exist.

• Growth-type investments located in variable annuities and IRA accounts, when taxable accounts exist.

• Fixed-income investments located in Roth IRA accounts, when traditional IRAs exist.

The goal of asset location is to increase the after-tax value of a portfolio by placing tax-inefficient securities in tax-deferred accounts and tax-efficient securities in taxable accounts.

Tax-inefficient securities have larger interest and non-qualified dividend income compared to tax-efficient securities which usually provide more capital growth. The compounding interest from tax-inefficient securities in a tax-deferred account should outweigh the increase in taxes paid on withdrawals from a tax-deferred account (ordinary income tax rate versus capital gains rate).

Every investor’s situation is different, so there is no easy answer in deciding where to hold assets. The “best location” for the asset depends on factors such as prevailing tax laws, investment holding periods, and the tax and the return metrics of the underlying investments coupled with the client’s unique tax situation.

The goal is to grow the portfolio while keeping taxes to a minimum. Investors should work closely with their advisor on the matters of asset allocation and asset location to create an optimal portfolio to reach long-term goals/objectives.

In addition to considerations related to the client’s unique tax situation, we rank the tax efficiency of all the asset classes we invest in for our clients. To generate our rankings, we evaluate expected rates of return, SEC/distribution yield, what tax rate is applied, and our expected capital appreciation. We use this data to further fine-tune a portfolio upon customizing an asset allocation based on the client’s risk tolerance and objectives.

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Victor J. Dzau, MD, gives expert advice
Victor J. Dzau, MD, gives expert advice