Successful investors are always looking for opportunities to improve their investment performance, reduce taxes, and increase their net worth. Asset allocation and asset location are two financial planning concepts that every successful investor should know. Asset allocation, an investor’s mix of bonds, equities, and other alternative investments such as real estate, has been the cornerstone of investment portfolio construction for decades as industry studies have clearly illustrated the long-term impact asset allocation has on investor volatility and return. Asset location, the lesser known of the two concepts, analyzes the appropriate account (i.e. brokerage/taxable, IRA/401k, Roth IRA) to hold bonds, equities, and other investments in order to maximize one’s after-tax rate of return.
To demonstrate the concepts of asset allocation and asset location when working with clients, let us introduce John and Jane Doe. John and Jane Doe are in their mid-50s with a current investment portfolio of $1M. Of that $1M, $500K of the assets are held in tax-deferred IRA accounts and $500K is held in a taxable brokerage account.
Through consultation with their advisor, they have analyzed their current investment portfolio, current income and spending levels, future expected rates of return, desired retirement ages, and other unique financial factors. Through this review, they have concluded to be balanced investors with 50% of their portfolio in various fixed income investments and the other 50% invested in various equity and alternative investments.
Once the allocation has been determined, we then focus on asset location as the second step in the portfolio construction process. When evaluating an asset location decision, the goal is to maximize the after-tax rates of return. For John and Jane, we would analyze the after-tax rate of return for bonds, equities, and other alternative investments, respectively, if held inside their IRA accounts as well as in their brokerage accounts.
The return and taxation assumptions associated for John and Jane were:
Rate of Return
Equities / Alternatives
Once these baseline assumptions have been established, we then review the after-tax rates of return based on holding the investments in various accounts. For the Doe’s taxable bonds, assuming a 5% rate of return and 25% ordinary income tax rate, the after-tax rate of return if held in their brokerage account would be: 5% * (1 - 25%) = 3.75% after-tax return, whereas taxable bonds held in their IRA would produce a 5% * (1 – 0%) = 5% after-tax return.
For equities, assuming a 10% rate of return and 15% long-term capital gain tax rate, the after-tax rate of return for equities held in their brokerage account would be: 10% * (1 – 15%) = 8.5% after-tax return relative to a 10% * (1 -0%) = 10% after-tax return holding equities inside their IRA accounts.
In our client example, the conclusion was to hold their bond portfolio in their IRA accounts given the tax benefit and their equity and alternative exposure in their brokerage account. The decision to hold bonds in their IRAs and equities in their brokerage account is backed up by industry studies. There have been several investment industry studies analyzing the benefit of an appropriate asset location strategy with some studies concluding the potential generation of an additional 0.20% to 0.50% of investment return, or $2K - $5K, on a $1M investment portfolio. These industry findings have also illustrated the impact this additional investment return provides each year from improved asset location over extended periods of time (i.e. working years of an investor), which generally results in materially higher net worth upon retirement for investors.
While our John and Jane Doe example was oversimplified for the purposes of this article, it does illustrate that maximizing one’s investment rate of return goes well beyond just selecting the highest performing asset classes each year. In our review, best practices for maximizing an investor’s long term rates of return and net worth are initial evaluation and decision on an investor’s asset allocation, analysis to then construct a portfolio to maximize one’s after-tax rate of return via asset location, and finally, on-going monitoring of one’s tax and investment portfolio factors.
Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
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