Asset LOCATION Is The Key To Building Wealth, Part 2

Today I’ll cover the second half of the Asset Location series.

The second study I referred to above was conducted by Spatt, and was published in June of 2004. This study focuses more on taxable bonds and equities, and essentially makes a recommendation in line with the usual thinking: place taxable bonds in tax-deferred accounts and then fill up those accounts with equities. Any remaining investment in equities should reside in taxable accounts. Here are the recommended steps as I see them:

• First fill your tax-deferred accounts with taxable bonds until your asset allocation is reached.
• Next add equities (or the next most tax-inefficient securities), provided your taxable accounts contain only equities. In other words you should not have taxable bonds and equities in your tax-deferred accounts if you also have bonds and equities in your taxable accounts. You should move your bonds from your taxable accounts into your tax deferred accounts and then use equities to fill in the rest of your tax-deferred and taxable accounts.
• If you’re worried about liquidity issues the study says that you can keep a small bond element in your taxable accounts, but that in general the benefits of keeping all of your bonds in a tax-deferred account will outweigh the risk of having to sell out of equity positions if liquidity (funds) are needed. I have an emergency fund, so I don’t expect to have any liquidity issues.
• The paper doesn’t recommend taxable over tax-free bonds in the taxable account. I take this to mean that it’s up to us to figure out if our after-tax yield is better with municipals than it would be for taxable bonds. This, of course, will be based on your tax bracket; the higher your tax bracket, the more likely it is that municipals will be a better choice for you.
• The paper mentions the first study I discussed (Shover), and argues that their solution is correct only if the equity investments are tax in-efficient and if they outperform similar tax-efficient investments. Their recommendation is to hold tax-efficient equity investments (i.e. index funds or individual stocks that are rarely sold). Therefore these two study are in agreement. They both recommend using tax-efficient equity investments and placing these investments in the taxable accounts.

This paper is full of wonder quotes and observations. Here are a few favorites:

“…the traditional approach to financial planning, in which the interaction between the taxable and tax-deferred accounts is largely ignored.”

I haven’t worked much with financial planners, but in general I believe this is a true statement. The paper refers to studies that show 40-50% of people who own equities in tax-deffered accounts also own bonds in taxable accounts. I think most financial advisors recommend a mix of stocks and bonds in both tax-deferred and taxable accounts, or they overweight equities in the tax-deferred accounts.

“When held in the taxable account, equity generates less ordinary income than taxable bonds, provides the investor with a valuable tax-timing option to realize capital losses and defer capital gains, and allows the investor to avoid payment of the tax on capital gains altogether at the time of death.”

The key point on this one is that investment in taxable accounts benefit from a “stepped-up” basis upon death. This means that your heirs won’t own any taxes on your taxable investments, but would have to pay taxes on (traditional) IRA distributions. I’m not a financial, estate planning, or tax adviser, so you should work with a professional if you find yourself in an inheritance situation.

“equity is less valuable when held in the tax-deferred account”

I’m assuming these is referring to the fact that you can’t harvest losses, manage your taxes, or pass on retirement funds on a stepped-up basis to heirs.

Two other factoids came up during my research. One piece of data that was thrown around was that only 15% of investors use index funds. The second was that investors can lose up to 20% of their after-tax returns by locating investments in the wrong type of account.

Summary: Asset Location is a major key to achieving long-term after-tax wealth. Asset location is also easy to overlook, and it can be a costly mistake to fix later in one’s investing timeline.

Image Credit: odalaigh

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