Asset Location

May 8, 2020

Improving After-Tax Return through Thoughtful Portfolio Positioning

As the old adage goes for real estate, “location, location, location.” The same can be said for the importance of where certain asset classes are held in an investment portfolio.

Why is this the case? The taxation of portfolio income varies by asset class: taxable bond and REIT income is taxed unfavorably at ordinary income rates, while equity dividends are taxed favorably at lower qualified dividend rates. An investor who has a combination of taxable accounts, Traditional 401(k)/IRAs and Roth 401(k)/IRAs can optimize a portfolio’s allocation to minimize tax drag thus enhancing long-term after-tax returns.

In order to better optimize a portfolio’s allocation, it is helpful to understand which asset classes are more tax-efficient than others.

The next step in the optimization process is reviewing which accounts types comprise the overall portfolio. For many investors, a portfolio may consist of a handful of taxable accounts (individual, joint, trust, etc.), Traditional 401(k), Traditional IRAs, Roth 401(k) and Roth IRAs.

Roth 401(k)/Roth IRA

Roth retirement accounts funded with after-tax dollars grow tax-free and qualified distributions are ultimately tax-free. Given the favorable tax status of Roth accounts, the goal should be to maximize return by allocating to asset classes with higher expected long-term growth.

  • Tier 1 – Actively Managed Equity Strategies
  • Tier 2 – Passively Managed Equity Strategies, REITs
  • Tier 3 – Energy-Infrastructure MLPs (beware of potential UBTI issues for individual MLP securities)

Traditional 401(k)/Traditional IRA

Traditional retirement accounts typically funded with pre-tax dollars grow tax-free and distributions are taxed as ordinary income. Investors with traditional retirement accounts should consider including less tax-efficient asset classes.

  • Tier 1 – High Yield Bonds, Emerging Market Bonds, REITs
  • Tier 2 – Core U.S. Investment-Grade Bonds
  • Tier 3 – International Bonds, TIPS

Taxable Accounts

After factoring in the allocations within Roth and Traditional retirement accounts, investors should utilize taxable accounts to “round out” the portfolio to arrive at a desired target allocation.

  • Tier 1 – Tax-Exempt (Municipal) Bonds (if applicable, see below)
  • Tier 2 – Passively Managed Equity Strategies, Energy-Infrastructure MLPs
  • Tier 3 – Actively Managed Equity Strategies
  • Tier 4 – Taxable U.S. Core Investment-Grade Bonds

As for whether an investor should invest in tax-exempt or taxable bonds for the core investment-grade bond allocation, the answer may come down to the investor’s marginal income tax bracket. Generally speaking, tax-exempt (municipal) bonds are more attractive if an investor is in a 32 percent or higher federal income tax bracket.                        

Putting It All Into Practice

To demonstrate the tax benefit of optimizing an allocation across various account types, we will look at an illustrative example of a portfolio without optimization versus a portfolio with optimization.

Assumptions:

  • John and Jane Smith have a $10 million investment portfolio split between three account types; $8.5 million in taxable accounts, $1 million in Traditional IRAs and $500k in Roth IRAs.
  • In this example, the portfolio is allocated as 50 percent Fixed Income / 40 percent Global Equities / 5 percent REITs / 5 percent MLPs
  • The Smiths are in the highest federal income tax bracket (37 percent) and are subject to a 5 percent state income tax rate
  • Taxable interest and non-qualified dividends are federally taxed at 40.8 percent (37 percent marginal rate + 3.8 percent NIIT tax)
  • Qualified dividends are federally taxed at 23.8 percent (20 percent qualified dividend rate + 3.8 percent NIIT tax)
  • For simplicity, the following analysis assumes no capital gains

In the first scenario, John and Jane have given little thought to asset location across accounts and whether to hold taxable versus tax-exempt bonds. In the second scenario, John and Jane have optimized the location of asset classes across the collection of taxable accounts, Traditional IRAs and Roth IRAs.

In scenario #2, the Smiths have allocated the Roth IRA strictly to higher growth asset classes such as global equities and REITs. We also see that the Smiths have used the Traditional IRAs to hold less tax-efficient asset classes – taxable bonds, REITs. Finally, the taxable accounts were used to “round out” the allocation by including municipal bonds, global equities and MLPs. In this instance, because the Smiths are in the highest federal income tax bracket, the Smiths will benefit from holding municipal bonds rather than taxable bonds in taxable accounts.

In this illustrative example, both portfolios have the same target allocation and same dollars invested across asset classes, with the composite portfolio yielding 2.56 percent. However, the optimized portfolio (scenario #2) has strategically allocated less tax-efficient asset classes within Traditional IRAs rather than in taxable accounts. For this reason, the taxable accounts in the optimized portfolio hold a more favorable mix of investments (more tax-efficient asset classes) which, in turn, produces a better mix of portfolio income. In total, the optimized portfolio results in lower taxes on portfolio income (approximately $39,000 lower), and thus a significantly lower tax drag (0.28 percent versus 0.67 percent).

Portfolio tax drag will ultimately vary among investors based on:

  1. Target allocation (fixed income vs. equities vs. real assets vs. alternative investments) and
  2. The amount of taxable versus tax-deferred investment assets

Simply stated, an investor whose portfolio is almost entirely taxable investments with very few tax-deferred investments will have limited ability to optimize the allocation. Conversely, an investor with significant tax-deferred investments will have greater flexibility to implement an allocation that minimizes tax drag.

In conclusion, strategic asset location can create meaningful tax savings, thereby enhancing a portfolio’s long-term after-tax returns. Taxable investors should consider asset location as an important component of a prudently designed investment plan.

Reach out to us to ensure your portfolio is properly positioned.


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