Asset Location

If you have been reading my blog for any length of time, you know how important asset allocation is to long term investment performance. Numerous academic articles and white papers have established that the manner in which funds are allocated into different asset classes is more important than any other factor which influences portfolio returns. Several sources suggest that as much as 90% of portfolio results are driven by asset allocation.

Today I would like to draw your attention to another factor which can significantly affect the returns you experience. I call it "asset location." It is the process of placing asset classes inside investment vehicles based on their tax characteristics.

Let's imagine an investor with a $1 million portfolio. This portfolio consists of three investment vehicles - $300,000 in a 401(k), $250,000 in an IRA and $450,000 in taxable account. Our investor earns $100,000. He's 50 years old and plans to retire in 10 years.

In this simplified scenario, the investor will have a portfolio consisting of 50% in equities and 50% in bonds. How should we allocate the $1 million across these two broad asset classes (equities and bonds) and across the three investment vehicles?

We know that bonds generally create income. Ordinary incomes taxes are 10%-35%. Our investor is in the 28% marginal tax bracket.

Equities can kick off dividends and capital gains. Qualified dividend income is taxed at 0%-15%. Our investor is in the 15% tax bracket. Short term capital gains are taxed as ordinary income. Long term capital gains are taxed at 0%-15%. Our investor is in the 15% tax bracket.

So, where do we place the $450,000 in bonds? These funds will go into either the 401(k) or the IRA. Why? Because the income coming from the bond funds we select will not be taxed inside these accounts. If we placed the bond funds in the taxable account, the income they create would be subject to a tax of 25%.

What about the equities? We should put these funds inside the taxable account. They may create some dividend income. If the dividends are qualified, the tax will be 15%. If the dividends are not qualified, the tax will be the ordinary income tax rate of 28%. Capital gains will be subject to tax at 15%. If we use exchange traded funds (ETFs), realized capital gains will not likely occur until the investor sells the ETFs.

Some investors might not think the asset location for tax efficiency makes much difference.

In this example, let's assume the equity return is 8% (2% dividends, 5.5% unrealized gain, 0% short term gains, and 0.5% long-term capital gains) and the return on the bonds is 3%. We'll assume the bonds are taxable, rather than municipal bonds.

If we locate the bonds in the non-taxable accounts (401(k) and IRA) and the equities into the taxable account (individual), in 20 years the investor will have $270,000 more than if we placed the bonds in the taxable account and the equities in the non-taxable accounts. This is an enormous difference and should serve to illustrate how important "asset location" is to Intelligent Investing.