Why I Use Asset Location Strategy

Bruce Primeau, CPA, CFP®, PFS |

Most people want to know how their investments are performing but what really matters is how they are performing on an after-tax basis. This is important because it is what translates into how much you can actually spend from your portfolio.

At SWA, we have developed an Asset Location Strategy (ALS) that encourages each client to build a globally diversified portfolio utilizing a passive, tax-efficient investment approach. We do this by advocating that clients build measurable balances across account types with different tax characteristics, including:

  • Taxable: Individual or Joint investment accounts, Employee Stock Purchase Plan, etc.
  • Tax-Deferred: 401(k), 403(b), Traditional IRA, Deferred Compensation Plan, Employee stock option plans, etc.
  • Tax-Free: Roth IRA, Roth 401(k) and 529 Plans

As each client adds to each of these tax classes, we install an overall asset allocation that is in line with their tolerance for risk. We manage holdings across all three account types in a manner that strives to maximize after-tax wealth. Here is an example of how a client portfolio with asset location is constructed and managed:

  • Taxable Accounts: We prefer clients own equities in taxable accounts as clients can receive tax-preferential rates for doing so. For example, qualified dividends and capital gains capital gains are subject to Federal tax rates of up to 23.8% (including capital gain surtax) compared to the top Federal ordinary income tax rate of 37%.
  • Tax-Deferred Accounts: Withdrawals from these accounts are generally taxed at ordinary income tax rates. Bonds create ordinary income so our preference is to have clients own bonds in this tax class. Because bond income is taxed at ordinary rates and typically client income is greater now than in retirement (when funds are withdrawn), bonds are typically less desirable to own in taxable accounts.
  • Tax-Free Accounts: Unlike the other two tax classes discussed above, gains from tax-free accounts can avoid taxation (assuming all distributions are qualified). Basically, the first two account types force you to share some of your gains with Federal and, for many of us, State tax authorities. But since Tax-Free accounts (primarily Roth IRA and Roth 401(k)) don't have this tax liability attached, we want clients to overweight them with investments that have the highest long-term growth potential, such as International and Emerging Market Stocks.

NOTE: This is meant as an illustration only and holdings will vary based on individual client circumstances.

Managing a client's portfolio in this manner will undoubtedly result in performance variances between each account due to the fact that what is owned in each account is unique and performs in different ways. For example, in 2017:

  • Most Taxable and Tax-Free accounts in an SWA asset location strategy performed well, which primarily hold stocks. Overall global stock index gained 24.0%1 before fees and transaction costs.
  • Most tax-deferred accounts lagged other tax classes due to heavier weightings in high quality bonds, which gained a more modest 3.5%2, also before fees and transaction costs.
  • While it might seem more appealing to have each account type invested to the same asset allocation and thus show a similar return each year, this can actually produce a less satisfactory result when taxation is considered.

For example, if each account in the portfolio is invested in the same asset mix, here are a few consequences.

  • Taxable accounts might hold positions in bonds, REITs, etc. which produce ordinary income each year that is taxable at a client's highest ordinary income tax rates. This produces an unnecessary tax drag on this portion of a client's portfolio.
  • Tax-free accounts may grow more slowly over the long term since the bond component held in these accounts is likely to produce less long-term annual returns than equity asset classes. This means you are not maximizing the account type that you don't need to share with the government!

Transaction fees to the client are significantly increased by having to purchase every holding in every account, as opposed to having a selected number of holdings in some accounts.
The bottom line is that there are ample reasons for SWA to manage client portfolios the way we do. From a long-term perspective, we believe this is the best way to maximize after-tax wealth and produce spendable cash flow from an investment portfolio. Our goal is to help our clients achieve their financial goals, even if a method might seem unconventional at first.

1Based on the returns of the MSCI All Country World Index NR USD. Source: Morningstar
2 Based on the returns of the BloombergBarclays US Aggregate Bond TR USD. Source: Morningstar