August 16, 2021
Effective Asset Location
David Furst, CFA, Advice Strategy
Taylor McLeod, Analyst
Saving money is a reliable way to prepare for financial goals such as retirement, a dream vacation, or funding a child’s education. To efficiently achieve these goals, individuals should be deliberate about which accounts they deposit their savings into; a concept known as effective asset location.
Perhaps one of the simplest ways to accumulate money is through a traditional checking or savings account. This ensures the wealth is liquid, easily accessible, and likely FDIC-insured up to a certain limit. Account-holders can utilize ATMs, online and mobile applications, and debit cards to manage transactions, making these accounts common for daily and emergency expenses. However, due to their near-zero interest rates and the long-term effects of inflation, the purchasing power of the funds actually erodes over time. In the hypothetical situation below, after 10 years, an initial $50 is worth less than $40, which affords 3 less cups of coffee.
Depositors also face opportunity cost risk. If an individual invests a portion of wealth in a diversified portfolio, they have the potential to grow the real value of their assets if the portfolio return outpaces inflation. This forgone additional growth is considered the opportunity cost of their decision.
In an effort to take advantage of hard-earned wealth, depositors should develop a personalized investing plan for their unique goals, risk tolerances, and circumstances. But what exactly should they invest in, where should they place it, and why? In this report, we will examine the types of investment accounts and the key factors to consider when sorting securities to maximize tax-efficiency.
The Main Types of Investment Accounts
There are three main types of investment accounts: taxable, tax-deferrable, and tax-exempt. Their unique characteristics impact the liquidity, tax treatment, and final earnings differently.
Certain accounts may be better suited to accomplish specific goals or to accommodate unique circumstances. For instance, tax-deferred and tax-exempt accounts are less liquid because premature withdrawals incur a tax penalty. However, their special tax treatment may be attractive for investors who seek retirement savings in a tax efficient way. Furthermore, investors who anticipate their tax rate might change over time, may want to consider the unique tax characteristics of each account type.
To illustrate this point, consider an investor who plans to invest a total of $10,000. Assuming he withdraws everything upon retirement, let’s look at how his final after-tax earnings differ if he invests all of his funds in a tax-deferred account versus a tax-exempt account given the scenarios that his tax rate stays the same, decreases, and increases.
Tax-deferrable accounts rely on the final tax rate when funds are withdrawn, and tax-exempt accounts only depend on the initial tax rate when funds are deposited. Assuming all else is constant, as long as the investor’s initial and final tax rates stay the same, then final earnings in both accounts are the same. However, if the investor believes tax rates will increase before retirement, they are better-off using a tax-exempt account, (which contributes after-tax dollars), taking advantage of the lower initial tax rate. Conversely, if they expect the final tax rate to decrease, then the investor may leverage a tax-deferrable account in order to postpone tax payments to a future period.
The average individual may be taxed at different rates over time for several reasons including changes in income level, marital status, or changes to the tax code. Throughout 2020 and 2021, Congress passed trillions of dollars in the form of fiscal relief programs to counter the effects of the COVID-19 pandemic and economic recession. In principle, these measures suggest increased future tax rates to fund the greater federal deficit today. This may ultimately affect the asset location decisions made by investors.
Because the varying tax treatments of these accounts ultimately affect an investor’s after-tax earnings, it is important to be deliberate when developing a unique asset location strategy and to regularly update your plan as circumstances change. Your Financial Advisor can help navigate this complexity.
Key Characteristics to Consider When Making Asset Location Decisions
Investors have the unique opportunity to offset gains by deducting realized capital losses from any realized capital gains in their portfolio. Any capital gains or losses only become realized after the security is sold. Because investments must be sold for losses to become realized, the ultimate asset location strategy comes down to a combination of risk level and holding period. Higher risk and higher return investments that are held for a short time are mathematically less volatile on an aftertax basis when placed in taxable accounts. This is due to the potential offset of taxable gains with any realized losses. On the other hand, for long-term investors interested in minimizing portfolio turnover, higher risk and higher growth potential investments may be better suited in tax-advantaged accounts which help defer or avoid taxable capital gains when the position is eventually sold.
Because risk may represent the chance of underperformance, loss of capital, or variability in returns over time. It is a key investment characteristic that impacts strategic decisions. In general, securities that offer a higher potential return carry a higher risk, and securities that offer a lower return potential exhibit lower risk. An investor’s personal risk tolerance contributes to their willingness and ability to bear risk, ultimately affecting their asset location decisions.
In general, stocks are more tax-efficient if held over one year. This is because realized capital gains qualify for a lower, longterm capital gains tax rate. The combination of higher return potential, a lower capital gains rate, and the ability to share risk and realized loss with the government, makes stocks a relatively tax-advantaged security.
On the other hand, bonds are generally tax-inefficient. Bonds pay a fixed interest rate that has often been lower than the average equity market growth rate. Additionally, any interest payments are taxed at the ordinary income rate as opposed to the lower capital gains rate. Conversely, it is important to consider municipal bonds and their tax-free income stream as the interest income is tax-exempt at the federal level, making them more tax-efficient in comparison to corporate and US government bonds. If municipal bonds are purchased by a state resident of the issuing state, they may fall under the triple tax-exemption – from federal, state and local tax. Work with your Financial Advisor and tax professional for personalized guidance on your unique situation as it may vary based on your residency.
Pooled securities such as ETFs, index funds, and mutual funds are subject to evaluation based on fund management and turnover rate. Many ETFs and index funds are generally considered tax-efficient because they are passively managed so there is less turnover and fewer transactions that trigger a possible taxable event. For those held over one year, realized capital gains are also subject to the lower capital gains tax rate. Mutual funds, however, can be tax-inefficient because they deploy more actively managed investment strategies and experience higher turnover. Because of the shorter holding periods, the higher short-term capital gains tax rate is imposed. Grouping securities by their tax-efficiency can maximize the unique benefits of each account type, and shield certain holdings from higher tax rates or additional tax treatments.
Implementing Effective Asset Location Strategy
Typically, investments can be ranked on a tax-efficiency scale that determines how advantaged or disadvantaged a security is when it comes to the tax treatment on its return. An investment’s tax-efficiency helps determine the ultimate asset location decision. As a general practice, investors may want to consider a security’s tax efficiency when creating an asset location strategy. The following graphic outlines the general grouping of various investments based on their characteristics and tax treatments.
While effective asset location decisions are accretive to after-tax returns, they do not replace proper asset allocation, the selection of high quality securities, and regular portfolio maintenance. Additionally, while these tax-efficiency-based asset location practices apply in the general sense, the ultimate decision is unique to the investor and can be complex. Your financial advisor can help sculpt a robust investment strategy to address your specific needs and preferences, and help you avoid missing out on any cups of coffee in the future.
RESEARCH, CHARTS, AND ILLUSTRATIONS PROVIDED BY JUANA DIEZ DE ONATE – WEALTH & INVESTMENT MANAGEMENT ANALYST
All investing involves risk, including the loss of principal.
This information is for educational purposes only. It is not intended to represent any specific return, yield or investment and does not constitute a recommendation to invest in any particular fund or strategy. It is not a promise of future performance, an estimate of actual returns or of the volatility any client portfolio may experience. Past performance is no guarantee of future results.
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