Location, Location, Location: When it Comes to Assets, Don’t Ignore Allocation

Many people focus on asset allocation with their investments but forget asset location.

While they might sound similar, they serve distinct purposes for a well-rounded investment and tax planning strategy.

What is Asset Allocation?

Asset allocation is the process of dividing your investment portfolio among different asset classes, such as domestic stocks, international stocks, bonds, cash, and alternatives.

Asset Allocation Key Factors:

1. Risk Tolerance: Risk tolerance is different for everyone and different asset classes come with varying levels of risk. For instance, all the stock asset classes generally offer higher potential returns but with higher volatility. Bonds and cash tend to be more stable but offer lower returns. Spreading out your asset allocation percentages helps you manage risk according to your comfort level.
2. Investment Horizon: If you have a long-term horizon, you might allocate more to stocks because despite their volatility they have historically provided higher returns over long periods. Conversely, if you’re closer to your financial goal, such as retirement, you might shift more towards bonds or cash to preserve your capital.
3. Diversification: Asset allocation inherently provides diversification. By spreading your investments across different asset classes, you avoid the potential negative impact of a single asset class performing poorly. This follows the adage of “don’t put all your eggs in one basket.”
4. Rebalancing: Just like your car needs regular maintenance, your portfolio needs regular maintenance too. Rebalancing is the ongoing maintenance of your asset allocation. Over time, your portfolio’s asset allocation may drift from your target asset allocation. Regular rebalancing maintains alignment with your risk tolerance and goals.

What is Asset Location?

Asset location involves strategically placing investments in different types of accounts (taxable, tax-deferred, and tax-free) to better position your tax efficiency.

Asset Location Key Pillars:

1. Taxable Accounts: These accounts don’t offer any tax advantages. You pay taxes on dividends, interest, and realized capital gains. Therefore, we believe it’s generally best to hold tax-efficient investments, such as exchange traded funds, individual stocks, or municipal bonds, in these accounts. These investments make the taxation easier to control and plan for.
2. Tax-Deferred Accounts: Pre-tax accounts such as 401(k)s, and traditional IRAs allow you to defer taxes until withdrawal. This makes them ideal for holding assets that generate significant taxable income, such as bonds, bond funds, real estate funds, alternative investments, or actively managed mutual funds. The income generated from these funds are not taxed because they are paid into a tax-deferred account.
3. Tax-Free Accounts: Roth IRAs and Health Savings Accounts (HSAs) are examples of tax-free accounts. Roth IRAs have after-tax contributions but withdrawals are tax-free if certain conditions are met. HSAs have pre-tax contributions, tax-free growth, and tax-free withdrawals if certain conditions are met. These accounts are well-suited for high-growth investments like stocks and growth funds.

The Goal of Asset Location:

• Managing Tax Efficiency: Employing asset location seeks to minimize taxes and to enhance your portfolio’s after-tax returns. This allows for increased dollars in your pocket and less to Uncle Sam. For instance, placing a heavier weight of bonds in a tax-deferred account can reduce your tax liability, and positioning a heavier weight of stocks in a Roth IRA allow you to benefit from tax-free growth.

Why Both Matter and How to Integrate Them

• Asset Allocation and Risk Management: Proper asset allocation is fundamental to managing risk and aligning your portfolio with your financial goals. Without a thoughtful allocation strategy, you could miss out on diversification benefits, potential returns, and appropriate level of risk.
• Asset Location and Tax Efficiency: Asset location, on the other hand, is about squeezing the most value out of your investments. Through strategically positioning them in accounts that provide many favorable tax treatments you can seek to create greater after-tax returns. This approach doesn’t change your risk profile but instead helps reduce the tax drag on your investments.
• Integrating Asset Allocation and Asset Location Together: Start with asset allocation. This builds your foundational investment strategy based on your risk tolerance. Next, apply asset location by selecting the most efficient investments for your respective account types (taxable, tax-deferred, and tax-free). Lastly, regularly tweak and rebalance your accounts so you are doing the most to better position your after-tax returns.

Christian Binger

Disclosures:

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Stock investing includes risks, including fluctuating prices and loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Because the administration of an HSA is a taxpayer responsibility, you are strongly encouraged to consult your tax advisor before opening an HSA.

The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results.