Location, Location, Location

The old adage in real estate is that the three most important considerations when determining a property’s value are location, location and location. The conventional wisdom when it comes to investment management is that asset allocation is the single largest contributor to long-term returns—something that, like the aforementioned real estate mantra, has been borne out by both extensive study and experience. Taking an individual’s taxes into consideration, however, reveals another factor of equal or greater importance, and one that has been primarily overlooked: asset location. We define asset location to mean the choice of investment vehicle an investor will use for each asset in the asset allocation.

When it comes to investment management research, taxes have been disregarded for a variety of reasons, and first and foremost among them is the element of uncertainty. None of us know today what our marginal tax rate will be next year; in general, changes in policy and the economic environment can impact our future earnings. There is even less certainty regarding what our tax rate will be come retirement. Furthermore, there is no way for us to know today what interest rates will be, nor can we know the long-term performance of the stock market or what our earnings and savings will be over the long-term. All of this uncertainty has resulted in executing financial planning assessments and studies from a pre-tax perspective, or with the assumption that we will have substantially lower tax rates in the future. If, however, we consider taxes a key factor and assume that the investor in question will be successful in accumulating wealth, then we can of course assume that taxes will be consequential. Indeed, incorporating taxes should have a substantial impact on asset location, if not asset allocation itself.

The typical high-net-worth investor may have a wide variety of vehicles available for asset location. These can include fully taxable accounts and tax-deferred accounts, such as 401(k), IRA, rollover IRA, deferred compensation, insurance, 529 and Keogh accounts. When ignoring or avoiding the impact of taxes, asset allocation is driven by the time frame for the investment. This has traditionally suggested that tax-deferred accounts be invested largely in equities, as the money won’t be accessed for a long time and should therefore be invested in the asset that will presumably provide the highest total return opportunity over the long-term, regardless of volatility.

This advice might be quite appropriate for people who save primarily through IRAs and 401(k)s, but if an investor has a larger and more diverse portfolio, asset location becomes increasingly important. It is also important to note that the federal government caps the amount of money that an investor can put into these vehicles¹.

These federal rates provide a distinct tax advantage for equities if they are held for more than 12 months in a taxable account. If equities are held in a tax-deferred account, the investor will effectively achieve the conversion of tax advantaged returns into fully taxable returns at an uncertain future tax rate. An investor with means can seek to hold these tax-advantaged returns in a taxable account and hold primarily (if not exclusively) fully taxable securities in tax-deferred accounts.

As can be seen in Exhibit 1, there is a substantial advantage for long-term capital gains and dividends versus income. The advantage increases from a 10% difference at lower levels of income and reaches a peak of 20% at higher levels of income. If an investor is seeking to maximize their wealth over time, then taxes must be considered, making asset location a key factor in achieving long-term wealth creation. As income increases, vehicles such as 401(k)s and IRAs can be largely populated with assets that generate income, short-term capital gains and/or non-qualified dividends. Let’s assume that an investor implemented a successful investment program in their twenties and has done sufficiently well that they will remain in one of the higher tax brackets at retirement. A focus on asset location would have resulted in investing tax-deferred monies in income-generating assets, notably bonds, and investing taxable monies in equities and other tax-advantaged investments including municipal bonds. The taxation of equities is complex relative to income, but generally lower. Capital gains are only taxable when a stock is sold and then they are taxed preferentially if held for the long term (greater than 12 months). If this investor had acquired a portfolio of high-quality stocks, it is conceivable that sales would have been minimal over the years and capital gains taxes could have been deferred or even avoided entirely, if held until death. Dividends would have been taxed at a preferred rate that is generally lower than the rate for passive income (this preferred tax rate for dividends has come and gone over the years, but is currently in place). If this same investor had focused on asset location and used tax-deferred accounts to buy bonds (and other fully taxable investments) across the risk spectrum over the entirety of their working life, they could have further optimized their investment program to minimize taxation and enhance wealth.

US Federal Income Tax Rates

The principles of effective asset location suggest that all of one’s fully taxable income-oriented investments should be held in tax-deferred vehicles. For most people, the most accessible tax-deferred investment vehicle they have is a 401(k) plan.

The Default Option

Target date funds are increasingly becoming the default investment option for 401(k) plans. These products tend to be heavily weighted toward equities in the early years and increasingly balanced as the target date approaches. This reflects the equity bias inherent in these tax-deferred accounts. When these accounts are liquidated, the cumulative contributions, income, gains and dividends are all taxed at the investor’s top marginal tax rate at the time of distribution. It is impossible to know in advance what rate this will be. What we do know is that it will be taxed as income and the investor will have effectively eliminated the beneficial tax rates associated with long-term capital gains and dividends.

If clients have the ability to save outside of these vehicles, then financial professionals might propose a dramatically different construct for a tax-deferred portfolio. These allocations can seek to minimize equities as a holding and maximize assets that seek to generate income and short-term capital gains. These vehicles might be largely populated with diversified portfolios of investment-grade fixed-income securities, high-income securities, equity securities that pay non-qualified dividends, and alpha strategies that rely on active trading and high turnover, generating a substantial portion of the return through short-term capital gains.

None of these strategies are typically found in a corporation’s 401(k) plan offerings and few advisors recommend these strategies in other tax-deferred accounts. Likewise, these strategies can be available through variable annuity contracts as they can protect the investor from adverse tax consequences, reduce the risk (and the cost, potentially) to the underwriting institution (assuming it provides a minimum guaranteed rate of return and the alternative investment would have been equities) and provide a reliable source of accretive income.

Conclusion

At all levels of income, long-term capital gains and qualified dividends enjoy a substantial tax advantage over passive income. As we would rarely advocate that municipal bonds be used in a tax-deferred account, we should emphasize that fully taxable assets be located in tax-deferred vehicles. Other assets that enjoy some degree of preferential tax treatment should be located in taxable accounts to derive the greatest benefit. Investors and their advisors can look beyond asset allocation and emphasize asset location in determining the construct of an investment portfolio. Tax-deferred vehicles are great tools for savings. Optimizing asset location can greatly enhance tax efficiency and enhance long-term wealth accumulation.