The cornerstone of investment management is asset allocation. This involves determining the right mix of stocks, bonds and cash, how much to tilt stocks toward small cap and value premiums, the right amount of portfolio “insurance” to hold in the form of gold, the right level of foreign exposure, and how much income to generate through high-yield stocks and REITs. But once this overall allocation plan has been decided, investors typically confront a second critical question, that of asset location. This also impacts a portfolio’s overall returns greatly.

Asset location refers to the placement of assets among accounts with varying tax protection. Many investors have both taxable (perhaps a joint brokerage account) and tax-deferred accounts (such as IRAs and 401(k)s). A clear long-term advantage can be engineered with smart asset location, or putting the right kinds of investments in the right kinds of accounts. Each investor has a unique capacity for utilizing taxable versus tax-deferred accounts, so there are no hard and fast rules. This article simply attempts to lay out the most important considerations when forming an optimal location strategy.

Why Asset Location Matters

To demonstrate, we create a hypothetical situation that requires many simplifying assumptions. This depiction ignores many complicating factors that arise when actually implementing and maintaining a multiple-account portfolio. But these omissions do not invalidate lessons derived from the exercise.

Consider a portfolio comprised of only two asset classes, stocks and bonds, each representing 50% of $1 million. We further assume that the investor holds two accounts, an IRA and a taxable brokerage account, and that each account holds $250,000 in stocks and $250,000 in bonds.

Simplified assumptions help illustrate the point. We assume that bonds return 4% annually generated entirely through interest payments and that stocks return 9% per year entirely through capital gains.[1] Bond interest income is taxable as ordinary income, but stock capital gains are taxable at an advantaged capital gains tax rate.  We assume a 25% income tax rate and a 15% capital gains rate. This is a “buy-and-hold” portfolio, therefore no rebalancing trades take place over a 20-year investment horizon. The full list of assumptions is outlined nearby.

Option #1 maintains a 50% stock and 50% bond allocation in each account. Option #2, or the tax-efficient option, rearranges the location to hold 100% stocks in the taxable account and 100% bonds in the IRA.

Optimizing a Hypothetical Portfolio

In this contrived example, Option #2, holding 100% of bonds in the IRA is the better alternative. The after-tax advantage after 20 years is almost $75,000, amounting to an annualized return difference of roughly 0.12%. This simply shows that it is often prudent to hold bonds in tax-deferred accounts when circumstances allow.

The bottom line is that capital gains accumulated in stocks are tax-advantaged and delayed until stocks are sold, so that the “tax deferral advantage” of an IRA is less valuable. Bond interest, on the other hand, is taxable as ordinary income upon receipt, meaning tax-deferral can be quite valuable. This advantage can easily be eliminated under different assumptions, but this example highlights why asset location should not be ignored.

More to Ponder

There are additional reasons to concentrate common stocks within taxable accounts:

1. Capital gains are already tax-deferred if stocks are not sold (as seen in the example).
   
2. Capital losses from stocks can be “harvested” to offset other income.
   
3. Shares of stock can be passed as a bequest, which results in a “stepped-up” cost basis and can eliminate capital gains entirely for heirs.
   
4. Appreciated shares can be donated to qualified charities to avoid taxation.

On the other hand, there are good reasons to hold bonds in taxable accounts:

1. Bonds have lower expected returns than stocks, especially in the current low-yield environment, and therefore the annual tax costs may actually end up being quite low for many investors.
   
2. Bonds typically have minimal capital gains, making re-balancing transactions and switching costs relatively low.
   
3. Some bonds, specifically municipal bonds, have tax avoidance features that can prove quite advantageous for high net worth investors.

At the end of the day, each investor should weigh these considerations in light of his own needs, overall asset allocation, and long term goals. Investors’ circumstances vary tremendously, so there is no “one size fits all” solution.

Tax-Efficiency

Asset classes can be loosely categorized on a scale of “efficiency” that can be used to build asset location guidelines. Generally speaking, tax-inefficient assets are those that generate returns largely through interest, income, or that regularly generate realized capital gains. Tax-efficient assets are those that generate returns largely through unrealized gains or pay out little investment income.

Municipal bonds are a special case. The interest from municipal bonds is not taxable at the federal level. Many states also offer state-specific municipal bonds that do not assess state taxes on income. Municipal bonds yields are lower than similar quality corporate offerings. For these reasons, municipal bonds should be held in taxable accounts and considered by investors in higher tax brackets.

Gold is treated differently as well. Realized long-term gains on gold are not granted the same tax treatment as stocks and bonds. Gold, including bullion-based ETFs, is taxed as a collectible. Long term gains for collectibles are taxed as ordinary income, with a maximum rate of 28%.

Many regard gold as a form of portfolio insurance rather than a source of expected return. In turn, realized capital gains may be minimal over a long time horizon. This leads some to hold gold in  taxable accounts, as no realized gains means no taxes. Moreover, any losses can be offset against gains taken on other assets. On the other hand, gold prices can fluctuate drastically in financial crises. During both the 2008 and 2020 downturns, many of our clients benefited from portfolio rebalancing. Highly appreciated gold positions were sold and the proceeds were reinvested in equities. Gains related to gold positions were subject to a maximum 28% capital gains rate. Many of these clients avoided taxable gains entirely from holding gold in their IRAs.

Comparing Asset Classes

Roth IRAs

For most investors, taxable brokerage accounts and tax-deferred IRAs and 401(k)s make up the bulk of retirement savings. However, many investors also hold tax-free Roth IRAs.

Contributions to Roth IRAs are “after-tax.” All growth within a Roth IRA is untaxed, as are withdrawals in retirement. Roth IRAs aren’t subject to required minimum distributions. As such, the Roth IRA is typically the last “bucket” used for retirement spending.

Because Roth IRAs are not subject to any taxes or required distributions, and therefore explicitly designed for the long-term, we prefer to hold high-expected return asset classes in Roth IRAs.

A typical Roth IRA may in fact be dedicated 100% to equity holdings, with significant international and emerging market holdings and tilts toward small cap and value stocks. This would put the Roth in the best position for long-term growth and tax avoidance. Keep in mind that if a Roth is 100% allocated to equities, the remainder of accounts for a household may need to be more conservative in order to balance the overall risk exposure.

To learn more about Roth accounts, investors are encouraged to read our recent article, “Roth Conversions: To Convert or Not Convert?”. An overview of AIS’ investment approach can be found here.

Conclusion

Optimal tax location does not lend itself to general rules, as it depends mostly on individual circumstances. But for any particular investor, an optimal plan often emerges from careful analysis. Please contact Luke Delorme at (413) 645-3327 or LukeD@americaninvestment.com for a complimentary portfolio review and tax analysis.

[1] In reality, bonds may provide capital gains or losses, and stocks are likely to provide annual dividend income. These assumptions are made to simplify the analysis.

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Disclosures

• Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of preparation and are subject to change.
  
• Prospective clients of AIS should not base investment decisions on back-tested performances as no client or investor achieved the same exact returns stated in back-tested performance. The purpose of the back-tested performance is to test the investment ideas and investment strategy developed to achieve stated results.
  
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), or product made reference to directly or indirectly, will be profitable or equal to past performance levels.
  
• All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance, strategy and results of your portfolio.
  
• Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio.
  
• Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results.
  
• Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.
  
• Disclaimer: Any tax advice contained in this report was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.