To Maximize Your Wealth, Think Like a Realtor

Forbes.com, Winter, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

Location, location, location.

Most investors have heard of asset allocation—spreading investments into different and hopefully non-correlated categories to maximize returns and mitigate risk—however,— few understand the concept of asset location—where the assets are housed in an investor’s portfolio—and how it can affect their wealth.

Almost everyone knows the benefits of saving on a tax-deferred basis (i.e., paying taxes when you withdraw the money instead of as it grows) and almost everyone knows there are a variety of tax-deferred vehicles (IRAs, 401ks, trusts, etc.). But what a lot of investors don’t know is the proper division of their investment dollars across taxable and tax-deferred accounts.

Simple Concept

Here’s a simple example: An investor with $200,000 is invested 100% in individual corporate bonds paying 4% and each bond is held to maturity before being reinvested in another bond paying 4%. Is there a difference in the end state of this investor’s wealth if these bonds are held in a tax-deferred account such as an IRA, versus a plain vanilla brokerage account that gets no special tax treatment?

The answer is yes. With the principal growing at 4% on a tax-deferred basis inside an IRA, the investor will have $419,000 at the end of 20 years (of course, they’ll have to pay taxes when they withdraw these funds). The investor who held the bonds in a brokerage account will pay taxes along the way. If they are in the 28% tax bracket, they will have just $352,897 at the end of 20 years.

So in this simple case, the investor with an asset location strategy that dictates assets be held in tax-deferred accounts does better than an investor whose asset location strategy dictates assets be held in only taxable accounts.

But this is a simple example at the extremes. In reality, it’s not so black and white. Investors typically hold a variety of investments that offer not just interest income, but capital gains (and losses!) and dividends, and as with some master limited partnerships, return of principal. And the variety of locations is not so black and white either. For instance, Roth IRAs are funded with after-tax dollars, while traditional IRAs are funded with pre-tax dollars.

Not So Simple Process

Given the number of variables at play, there is no simple formula to determine the right asset location strategy, but as the above example shows, not having any asset location strategy can cost you dearly.

Remember, the goal of an asset location strategy is to get the most out of the “end game” i.e., after-tax wealth, and to minimize taxes over the investor’s lifetime. In short, it’s an upfront tax planning exercise to maximize future results.

In choosing where to house investments, and in what concentration, you and your advisor would consider such factors as age, time horizon and sensitivities to assuming full, partial or any required liquidation events (such as one or more required minimum distributions or annuity payouts), while taking into account your current and future tax burdens, as well as potential capital gains.

In considering the placement of each investment, you and your advisor would consider such questions as:

  • Is it better for an investment to grow at a pre- or post-tax rate?
  • Is it better for an investment to be left alone or to be turned (in whole or in part) into something else, such as a trust or annuity?
  • Is it better to pay the tax now or later when the investor is in a different tax bracket?
  • How do the horizon, withdrawals, carry-forward losses, concentration of assets and other exposures all fit together?

While enhancement of after-tax wealth is the ultimate goal of any asset location methodology, taxes aren’t the only expense to be considered. A good asset location strategy also looks at hidden costs such as investments in managed or multi-manager vehicles versus passive accounts, and the legal fees associated with holding assets in trust.

Approaches To Investment Placement

There are two ways to approach asset location, known respectively as “the sum method” and “the difference method.” The sum method is often used to prioritize the order in which investors would locate allocations. The difference method presents the issue in terms of what difference would one location over another mean to overall end-wealth. Both methods should provide answers that may not be exactly the same, but nonetheless offer some consensus as to where investments should be placed and why.

Generally, investments with potentially large capital gains (aka “tax-inefficient high-return classes”) are often better off growing in pre-tax accounts. This means investments such as large-cap stocks, real estate, commodities and absolute return vehicles are often better off in an IRA.

By comparison, tax-efficient assets, such as investment-grade bonds, are usually better off in an after-tax vehicle, such as a brokerage account. Emerging market investments are a sort of “swing class” and would have to be considered on an individual basis.

Asset location would not preclude something like putting bonds in an IRA, but it would help establish an order and priority in determining where and how much of one type of investment should be placed in any particular vehicle.If your advisor is already guiding you through yearly tax-loss harvesting and periodic rebalancing, you are on the path to getting the right asset location strategy for your portfolio. At your next meeting ask your advisor what the asset location strategy is, and if it turns out there isn’t one, roll up your sleeves and get to work on it.

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