One of the ways a high-quality advisor adds value is by paying attention to asset location. Low-quality advisors tend to ignore it. There are three reasons they may do so:
- They don’t care. The advisor may have the cynical view that clients only focus on pre-tax returns so don’t worry about it. If the primary objective is sales rather than actually doing the best possible job, this makes sense.
- It’s too hard. It adds operational complexity. Particularly for advisors with a high number of small accounts, it is easier to just “mirror” all the accounts exactly the same way.
- They don’t know. They either don’t know about the strategy at all, or don’t know how to implement it.
Taxes should not determine asset allocation (though it may influence it slightly at the margin), but once the proper allocation is determined, location is important. Optimal asset location is simply locating the least tax-efficient assets inside of tax-advantaged (i.e. retirement) accounts and the most tax-efficient in taxable (i.e. non-retirement) accounts. A combination of three factors are multiplied together determine tax efficiency:
- Investment return. An investment with a rate of return of 0% (e.g. cash) is perfectly tax-efficient. The higher the return the lower the efficiency.
- Tax rate. An investment with a tax rate of 0% (e.g. munis) is perfectly tax-efficient. The higher the rate (e.g. ordinary income vs. long-term capital gains) the lower the efficiency.
- Turnover. If an investment is never sold, under current tax law there is a full “step-up” in basis at death and thus is perfectly tax-efficient. Keep in mind that yield (dividends and interest) are a form of turnover. The higher the turnover the lower the efficiency (basically, there can be “good” turnover where losses are being harvested). In the case of a mutual fund, use the higher of the expected fund turnover or the inverse of the investor’s expected holding period in years but not more than 100%.
In addition to the three factors above, there are two more things to keep in mind:
- Volatility. An investment with high volatility is more valuable in taxable account because of the possibility of being able to tax-loss harvest in an early year. Of course, more volatile investments also tend to have higher expected returns which I noted above are better held in tax-advantaged accounts. In general, I would say the expected return dominates the volatility, but it is something to keep in mind.
- Foreign source income. Foreign investments (e.g. foreign stock funds) are better held in taxable accounts so as to be able to take a credit or a deduction (the credit is usually better) for foreign taxes paid. The effect is partially offset by the fact that the yields on foreign stocks tend to be higher than those on domestic stocks which I noted above would indicate holding the higher-yielding investments in the deferred account. In general, I would say it is just slightly better to have the foreign stocks located in the taxable account.
There are two types of tax-advantaged accounts, tax-deferred (e.g. traditional IRAs, 401(k) plans, etc.), and tax-free (e.g. Coverdell and 529 accounts if used for education, Roth IRAs, etc.). Between those two, because (under the current tax code) the Roth does not have RMDs (Required Minimum Distributions), it is better to have higher returning assets located in the tax-free accounts. Most people think that the reason is because it is tax-free, but this is not so. There is no difference between a Roth and an IRA except the investor owns 100% of the Roth while (assuming a 25% tax rate) she owns only 75% of the IRA (the government is a 25% partner) but both are completely tax-free once you make that initial adjustment.
Again, the most tax-efficient assets are optimally held in the taxable account and the least tax-efficient in the tax-advantaged accounts. But suppose relatively large amounts of inefficient holdings are end up in the taxable account anyway (either because the size of the tax-advantaged accounts is small or the holdings are large, or a combination). For example, suppose the least tax-efficient holding in the taxable account is a total bond market bond fund (all ordinary income). Particularly if interest rates are higher (say 6% rather than the current 2.3%), there are five things to consider doing to improve the tax efficiency:
- Buy a municipal bond fund instead. This is particularly appropriate for high-tax-bracket investors.
- Make non-deductible IRA contributions. While I would not make non-deductible contributions if the marginal holding is eligible for capital gain treatment and might receive a step-up on death, in a case where it is already ordinary income this probably makes sense. The downside is the loss of liquidity if the investor is younger than 59½.
- Use a variable annuity wrapper. This is exactly like the previous recommendation of the non-deductible IRA from a tax perspective, but has additional cost. Despite the additional cost, if it is cheap enough (and I have in mind a plain-vanilla annuity with no riders at 25-30 basis points) and the time horizon long enough, this can make sense (not today, but in a higher interest rate environment). I have discussed this option here.
- Buy permanent life insurance. I am not a fan of permanent life insurance in general, but as I have noted before there are rare cases where it is recommended. Ordinary-income holdings like bonds in the taxable account is one of the factors.
- Pay down your mortgage instead. There are many other aspects to this decision also which I have covered here.