Asset Allocation is one of the fundamental concepts of financial planning. Whether you are taking your first investment class, or meeting with your advisor for the first time, it is nearly a guarantee that you will hear that phrase at least once. The reason for this is that your asset allocation is what will be used to project your future market gains and losses. For those allocating more of their portfolio to riskier asset classes, such as stocks or high-yield bonds, you might expect large fluctuations between your annual returns depending on how the market performs.
On the other hand, those allocating larger portions to cash, CDs, or Treasuries should expect to see comparably less short-term volatility (though this allocation might result in lower long-term growth expectations). While getting extremely lucky and/or unlucky with a stock selection can definitely swing your rate of return on its own, that dynamic is far less predictable over time. Thus, asset allocation is the primary driver when it comes to projecting the future risk/return of your portfolio.
While Asset Allocation is absolutely an essential part of your investment plan, there is another similar concept that unfortunately receives far less recognition: Asset Location. For most, this might be the first time you have seen that term. If that is the case for you, then you are the exact reason why we are diving into this topic. Asset Location gives us the opportunity to be much more strategic with our investment planning, and it takes the idea of Asset Allocation to an entirely different level. Below, we will discuss how it works, along with how each account type can take advantage of this strategy.
What Is It?
Simply put, Asset Location takes your desired Asset Allocation and strategically assigns those assets to different accounts based on both their tax benefits and their investment objectives. For this article, we’re going to use the classic “60/40” portfolio as our assumed asset allocation target. This means taking 60% of your portfolio and allocating it towards stocks, then taking the remaining 40% and allocating that portion towards bonds. Let’s also assume we have one of each account type: one taxable brokerage account, one Traditional IRA (or Traditional 401(k)), and one Roth IRA.
In most cases, an investor would simply take 60% of each account and allocate it towards stocks, and then the remaining 40% of each account would go towards bonds so that all three match the target allocation. Asset Allocation, however, will look quite a bit different from this traditional approach.
Taxable Account
Let’s start with your brokerage, or non-qualified, investment account. Unlike Traditional or Roth IRAs, the brokerage account does not come with any special tax advantages. Any time your investments pay dividends, interest, or distribute capital gains, you are taxed for that year on the proceeds. This is the case regardless of whether you choose to re-invest, leave as cash, or send to your checking account for you to spend. With that knowledge, it could be argued that the taxable account is perhaps the greatest opportunity available for you to strategically allocate your investments.
What we typically start with, assuming you are not prioritizing income from your investments currently, is taking bonds out of your taxable account. The reason for this is that bonds typically pay interest semi-annually, and that interest is taxed at your ordinary income rates. Specifically, we would prioritize removing bonds that do not come with any tax advantages (municipal and U.S. Treasury bonds are examples of bonds that actually do have certain tax advantages).
On the other hand, if you have qualified dividends or capital gains from the stock portion of your table account, those can potentially be taxed at capital gains rates instead. Not only can capital gains rates be much lower than ordinary income rates (depending on your tax brackets), but if you are Married Filing Jointly in 2024 with a taxable income of $94,050 or below, you could potentially pay 0% federal taxes on your qualified dividend and capital gain income. If you need at least some income, this is the more tax-advantageous way to receive it; however, if no income is necessary, prioritizing investments that pay little or no interest/dividends at all (such as growth stocks) can further lower your tax liability.
Traditional IRAs/401(k)s
We now understand the tax advantage of having less ordinary income in your taxable account, but what happens to the rest of your bond allocation? If you increase the percentage of stocks in your brokerage account, you would then need to increase the bond allocation somewhere else to even things out. The place to do this is generally your Traditional IRAs or 401(k)s.
There are usually two main reasons why we do this: first, traditional IRAs/401(k)s are tax-deferred, so that ordinary interest income that we were wanting to avoid can now be deferred entirely (assuming no withdrawals from the account are made during the year).
Secondly, your tax-deferred accounts will be taxed as ordinary income upon distribution anyways, so you are not missing out on any special tax advantages that bond interest could have. As we discussed earlier, stocks that pay qualified dividends can receive capital gains tax treatment, but if they are in an IRA, those dividends will eventually be taxed as ordinary income once your distribution is made.
Lastly, the investment time horizons of these accounts need to be factored in. With a taxable account, you are never forced to take money out. If you would like that account to grow and remain untouched indefinitely, then you may do so. However, Traditional IRAs and 401(k)s do not have this same flexibility.
Currently, at age 73, you will need to begin taking Required Minimum Distributions. These are amounts based off your life expectancy and your total account balance as of December 31st of the previous year, and this amount must be taken out by December 31st of the current year (the only exception to this rule is in your age 73 year, where you technically have until April 1st of the following year). This rule means that we have a definite time horizon on this account when funds must begin to be drawn out, so the extra bond allocation will allow you to have less volatility in the accounts that you are being forced to draw from on an annual basis.
Roth IRAs
The last account type is the Roth IRA. The Roth can be extremely valuable due to its ability to, depending on if certain requirements are met, allow for tax-free distributions. Generally, this means having the account for at least 5 years, and being at least 59.5 before taking any money out. The tax-free aspect often means that we like to have the most aggressive parts of the portfolio placed here. In a perfect world, we would like for as much of our long-term growth to come from the tax-free bucket of our portfolio if possible.
Typically, this would be growth stocks that do not focus on dividend income (or, if you do not need dividend income and have already added the growth stocks to your taxable account, you can place your dividend stocks in a Roth to avoid paying capital gains taxes). Additionally, since Roth IRAs do not have Required Minimum Distributions, there is not a finite time horizon like you have on Traditional IRAs. This means that during negative market periods, you can leave your Roth alone and wait for it to recover.
It is also important to note that, if the aforementioned requirements are already met, Roth IRA distributions are also tax-free for your beneficiaries. For those not wanting to burden their beneficiaries with taxes, Roth IRAs can be a great vehicle to pass on assets that you would like someone other than yourself to eventually spend.
Conclusion
As we have discussed, each account type has different considerations that could potentially make certain assets more favorable than others. However, it is always important to remember that financial planning needs to be personalized for your situation. For some who have large taxable accounts and need current income, getting rid of bonds like we discussed earlier might not be optimal for you. Furthermore, someone who is in a high tax bracket now but expects to be in a low tax bracket later might not want to utilize Roth IRAs, and so all of their IRA assets would go to the Traditional IRA. In that case, the growth portion that we discussed going to a Roth would need to be absorbed by a different account type. These are just two of many examples where the above scenarios could need to be adjusted.
There are many takeaways from this article, but we want to highlight two main ones:
1) There are major benefits available to being intentional about what assets you hold in each specific account type, and
2) the potential benefits, and the ability to take advantage of them, will rely primarily on your own goals, income, tax brackets, and risk profile.
If you feel like your portfolio has never taken advantage of asset location, or you feel like you could be doing a better job of it, please do not hesitate to contact us!
Matt J Black,CFP®, AAMS®
mblack@larsonfs.com
913-428-2233
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