Location, Location, Location: A Primer on Asset Location

In the construction of your portfolio, asset allocation, investment selection, cost containment, and tax efficiency may be the most important decisions that you face. Each of these decisions affects the performance of your portfolio to varying degrees, some more significantly than others as described in Todd's article. Structuring a tax-efficient portfolio through asset location has the potential to maximize the after-tax return of the portfolio. The term asset location refers to the strategic placement of specific asset classes in either a taxdeferred account or a taxable account depending upon the tax efficiency of the asset class and the benefits provided.

A typical portfolio usually consists of taxable accounts and tax-advantaged retirement accounts funded with multiple asset classes. Asset location maintains that investments that tend to lose less of their return to income taxes should be placed in taxable accounts (trusts) while investments that lose more of their return to income taxes be placed in tax-deferred accounts (IRAs and 401Ks). Asset location achieves this objective by identifying the optimal location for each asset class. For simplification, the primary asset classes referenced in this discussion are stocks and bonds.

When implementing asset location, the factors to be considered for each client's portfolio range from their cash flow needs, tax bracket, prevailing tax laws, and the tax characteristics of the asset classes. This method of placement has the potential over time to add value over a pro-rata approach to funding each account within a portfolio. The pro-rata approach structures each account similarly, while the asset location methodology determines the location of each asset class based on where it provides the most after tax benefit to the portfolio.

The Tax Relief legislation of 2003 (JGTRRA) provided greater incentive and opportunity to implement asset location by reducing the tax rates on qualified dividend income from ordinary tax rates to a maximum rate of 15%. Broadly speaking, most, but not all, qualified dividends are generated by stocks held in your equity mutual funds. In the past, dividends from equities were not receiving preferential tax treatment. As a result, it made sense to hold equities in retirement accounts to avoid paying tax on the dividend income until that income had to be withdrawn. The reduction in tax rates for qualified dividends was a strong factor in the support of implementing asset location in the structure of your overall wealth to minimize tax ramifications. This adds value over time to the after-tax return of the portfolio.

Conversely, taxable fixed income investments and REITs generate non-qualified dividends making them more suitable investments for retirement accounts such as IRAs. Non-qualified dividends do not receive preferential tax treatment, which subjects the income to ordinary income rates regardless of where the assets are housed. With that being the case, placing these assets in retirement accounts such as IRAs provides the opportunity for tax-deferred growth and the deferral of tax on the income until withdrawn.

Roth IRAs are generally excluded from the general principles of asset location due to the fact that qualified withdrawals are tax-free. Therefore, assets that have the potential to generate higher returns make good candidates for Roth IRAs.

When reviewing your quarterly statements, if you have any questions as to the location of your assets, please give us a call or list it on your agenda for discussion at your next review.