You likely have heard the saying that the three most important factors in real estate are location, location and location. In wealth management, location is a similarly important factor.
Asset location is a best practice for keeping as much of your wealth as possible — after taxes have taken their toll. Inefficient tax planning can be very costly, so it is worth knowing more about how to benefit from proper asset location.
What is asset location?
It is important to note that asset location should not be confused with asset allocation. The two are related, but different portfolio management techniques.
Asset allocation is dividing your money among different asset class holdings — such as 50% stocks, 50% bonds. The purpose of asset allocation is to create an appropriate balance between seeking higher market returns while managing risk.
- Asset location is deciding what taxable or tax-favored account should hold a specific investment. The purpose of asset location is to invest as tax-efficiently as possible. Tax efficiency is the measure of an investment’s profit after taxes are paid.
How does asset location work?
By locating your least tax-efficient investments in your tax-sheltered accounts, you can minimize or even eliminate tax inefficiencies. For example, typically, but not always, holdings such as fixed income and real estate investment trust (REIT) mutual funds are less tax-efficient than stocks. Therefore, it might be reasonable to hold them in a tax-favored account such as a traditional IRA.
It makes sense to locate these and other asset classes according to their expected tax efficiencies. But it’s not as easily implemented as you might think. First, there is only so much room in your tax-sheltered accounts. After all, if there were unlimited opportunity to avoid paying income taxes on your investments, you’d simply shelter all of them. In reality, challenging tradeoffs must be made to ensure you’re making best use of your tax-sheltered “space.” Second, it’s not just about tax-sheltering your assets, but also when and how you plan to use your investments. Eventually, you’ll also want to spend or bequeath them, so you want to plan for that too. Here are some ideas on how to do that.
Managing your bigger picture – Before deciding where to locate your assets, first determine your proper asset allocation based on your unique goals and risk tolerances. Only then is it appropriate to determine where those holdings should reside for tax efficiency.
Planning for your goals and time frame – Is retirement near or far? Do you want to leave a legacy? Is your net worth likely to change in the next few years? These spending, estate planning and other needs may override or at least influence your optimal asset location.
- Managing tax-sheltered accounts – What are your tax-sheltered account opportunities among Roth IRAs, traditional IRAs and company retirement plans? How much room do you have in each, and which specific holdings, in which exact accounts, are expected to give you the most tax-efficient outcomes? How might evolving tax codes impact your plans?
- Considering other tax-planning needs – You should also consider the benefits of holding assets in taxable accounts, such as being able to use foreign tax credits from international investments, harvest capital losses against capital gains, allow your heirs to receive a step-up in basis upon inheritance and/or donate highly appreciated shares to charity to reduce capital gains taxes.
The art and science of asset location
While you may not even know if you are missing out on optimal asset location, the resulting wealth unnecessarily lost to taxes can be very real. Here are some reasons your asset location planning may fall short.
Missing pieces – Through the years, families usually accumulate a jumble of individual and retirement plan accounts and financial service providers. As your assets grow, it becomes an increasing challenge to organize them into a cohesive whole.
Missing expertise – Even if you have a handle on all your holdings, effective asset location should be considered within the multiple, often competing components of your total wealth. This calls for multidisciplinary oversight across investment management, tax planning and estate planning alike.
- Missing oversight – Asset location is not a set-and-forget activity. As your own goals, the market and government regulations evolve, your assets require ongoing management to retain their desired efficiencies.
It’s an art and a science to apply effective asset location to your unique, often complex wealth management. That said, the efforts can pay for themselves many times over by minimizing taxes for you and your heirs.