As the largest determinant of both risk and return, portfolio asset allocation is critical.
Once we work with the client to select the asset allocation, it is imperative that those assets are located where they are most tax-efficient.
- Read more: New Rules for Asset Location
If, for example, we had a client allocation of 60% equities and 40% fixed income, we have the opportunity to design the portfolio for tax-efficiency. This would require looking at taxable accounts, tax-deferred accounts, and tax-free Roth accounts. For taxable accounts, the broad stock index funds or individual stocks we plan to hold on to for years are best. That’s because the dividends are taxed at a lower rate and the capital gains can be deferred indefinitely. In fact, the capital gains tax can be avoided altogether with the step-up basis after death. Tax-deferred accounts such as an IRA, 401(k), 403(b), or profit sharing plan are perfect for investments taxed at the highest rates. Those include REITs, bonds, CDs and stock funds generating capital gains, especially short-term capital gains. Roth accounts are a bit more complex in deciding which assets to choose for this location. In general, low-turnover stocks and stock funds are best located in taxable accounts, followed by the Roth accounts, but situations can vary. In fact, even tax CPAs get this asset location wrong. That’s because we are taught that IRAs and 401(k)s are for long-term investing and stocks are for the long-term. But the overall return is set by the asset allocation and the selection of the securities. Asset location merely increases the return by paying less tax. Of course clients will want some emergency funds in their taxable account since they may not be able to spend retirement assets for unexpected emergencies, which is fine. It’s not even that detrimental if the client has to sell stocks in their taxable account at a time when stocks have tanked. We can simultaneously sell the fixed income in their retirement accounts and buy a similar amount of the same stocks or funds to avoid selling after a plunge.Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.