The financial services industry has long promoted the concept of asset allocation as the critical component of a successful investment strategy.
But financial advisors now face an additional challenge, maintains Michael Kitces, research director at Pinnacle Advisory Group Inc. of Columbia, Md., in determining not only which asset classes should be owned and in what amounts, but also where those asset classes should be held.
Drawing on an early paper by American financial planners Gobind Daryanani and Chris Cordaro entitled Asset Location: A Generic Framework for Maximizing After-Tax Wealth, Kitces argues that good “asset-location” decisions should be influenced by both the tax efficiency of the investments and their expected returns.
In a simplified, two asset-class portfolio, the principles of asset location are relatively straightforward. It’s generally more appealing to put bonds in a tax-sheltered account and stocks in a taxable account. This way, the growth in equities is taxed at preferential capital gains rates instead of ordinary income; bond income that would otherwise be fully taxable annually will instead accrue tax-deferred income that will be taxed just once, upon withdrawal.
The potential drawback of this simple scenario is that it assumes that bonds are maximally tax-inefficient and stocks are maximally tax-efficient.
In practice, though, this is rarely the case, both because most equities generate a portion of their long-term growth via dividends – which are taxable when received, albeit at favourable rate – and because even conservative buy-and-hold portfolios ultimately experience some turnover, if only due to rebalancing over time. Also, Kitces says, most clients own more than just two asset classes, and certainly more than just two individual investment positions.
In addition, clients are not likely to have an equal division of wealth between their taxable and retirement accounts, particularly now that tax-free savings accounts are starting to play a more significant role in portfolios.
The process is further complicated by the fact that different clients may have different tax rates and income-splitting strategies, which can affect the relative benefits of putting various asset classes into one account or the other.
Instead of trying to calculate every permutation of holding investments in various accounts to see which strategy results in the greatest projected wealth, Kitces says, advisors should adopt an after-tax prioritization process. Ranking assets this way will make it easier to know what investments to place in which account for each client, without needing to calculate the results of every possible account combination.
There is, however, one more key factor to evaluate when considering asset location: the expected return on the investment. It’s no longer enough simply to know the potential tax rates that will apply to an investment and its tax efficiency, particularly in a period of low interest rates.
After all, if the reality is that the expected return is very low, Kitces warns, there’s simply not much benefit to tax deferral in the first place. Avoiding the consequences of tax drag just doesn’t matter very much when there’s simply not much return to compound in the first place.
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