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Puzzles and Asset Location Investing

June 24, 2020 BY Mark Haser

My wife gave me this puzzle for Father’s Day this year. My 3-year-old absolutely loves puzzles, so I think we did the puzzle about 10 times the very first day. He can almost do the whole thing by himself. I’ve been teaching him the basic rules for solving a jigsaw puzzle:

  • Put the corners in place first
  • Next try to find the edge pieces and put them in place
  • Group similar colors together
  • Look for pieces that are easy to identify first
  • I’m sure you can think of more!

He still occasionally tries to put edge pieces in the middle and vice versa, but it has been a lot of fun to watch him get better and faster at solving it.

Asset Allocation vs. Asset Location

You’ve probably heard of asset allocation—the decision of how to allocate your capital across different asset classes (e.g., stocks, bonds, real estate, cash). While asset allocation is the most important decision an investor has to make, asset location, as part of an overall tax-sensitive approach to investing, may be the second most important. Asset location is nothing more than figuring out in which type of account (taxable, tax-deferred, tax-free) to hold each asset. The basic principle is that you want to put your most tax-efficient investments into taxable accounts and your most tax-inefficient investments into tax-deferred accounts. Doing so will give you the best chance of maximizing your after-tax return—the money you actually get to keep!

Constructing an investment portfolio using the principles of asset location is a bit like solving a jigsaw puzzle. From the basic principle above, several strategies emerge:

  • Put your stock investments in a taxable account. Equity tends to be the most tax-efficient asset class, especially index-based mutual funds and passive exchange-traded funds (ETFs). When you sell a stock, it will generate either a capital gain or a capital loss (hopefully a capital gain!). If you have your stocks in a retirement (tax-deferred) account, while you get to defer taxes owed on any interest and dividend payments, you lose out on the favorable capital gains tax rate and instead you pay taxes on the gains at your ordinary income rate.
  • Other reasons to put your stock investments in a taxable account include: (1) in a tax-deferred account you lose the ability to “harvest capital losses” (2) you lose the ability to donate your appreciated stock to charity (with the notable exception of making a Qualified Charitable Distribution[1]) and (3) perhaps worst of all, you lose out on one of the biggest tax breaks available—the potential to eliminate your capital gains altogether by taking a step-up[2] in basis upon your death.
  • Hold your taxable bonds and real estate investment trusts (REITs) in a tax-deferred account. These assets are generally tax-inefficient, and by placing them in a tax-deferred account you don’t have to pay any taxes on them until after you take your money out of the account. You might also consider high dividend yielding equity in a tax-deferred account as well.
  • The exception for bonds is municipal bonds. You should only ever hold these in a taxable account as municipal bonds are specifically exempt from taxes. If you put a municipal bond in a tax-deferred account, you end up having to pay ordinary income tax on it. Believe it or not, I have seen professionally managed retirement accounts chock full of municipal bonds.
  • Place your most aggressive, highest potential returning assets in a Roth account (Roth IRA or Roth 401k/403b). Assets held in Roth accounts will never be taxed. Wouldn’t it be nice if you had bought Amazon in your Roth account 20 years ago?
  • Hold foreign stocks in a taxable account in order to claim the foreign tax credit for dividends that are taxed by the originating country. Admittedly, we are getting down to smaller potatoes here, but every bit of “tax alpha” helps.
  • Consider putting actively managed funds in a tax-deferred account before any of your passively managed funds. Actively managed stock funds are less tax-efficient than passively managed stock funds (i.e., they have a higher turnover rate[3] and therefore pass through more capital gains to investors).
  • Consider putting any small cap and value funds into a tax-deferred account before any of your large cap or growth funds. Small cap and value tend to have higher turnover than large cap and growth funds, thus they tend to be less tax-efficient.

It is important to note that all of the above asset location decisions assume you have taxable, tax-deferred, and tax-free accounts, and does not mean you shouldn’t put stock in your retirement account if you only have a retirement account. It also doesn’t mean you shouldn’t put bonds in a taxable account if the purpose of those bonds is to mature at a specific point in time to safely fund a car purchase, house down payment, or other financial goal. You get the point.

The Bottom Line

When constructing an investment portfolio, you can use the basic principles of asset location investing to create a tax-efficient portfolio that provides you with a higher after-tax return. When you create a portfolio using asset location investing, bear in mind that each of your accounts can look very different from one another, so it is important to periodically review them as a whole and ensure that your overall allocation is in balance. It can be a bit of jigsaw puzzle, but just try not to put the edge pieces in the middle!

 

[1] A Qualified Charitable Distribution (“QCD”) is a direct transfer of funds from your IRA to a qualified charity. QCDs can be counted toward satisfying your required minimum distributions (RMDs) for the year. In addition to the benefits of giving to charity, a QCD excludes the amount donated from taxable income, which is unlike regular withdrawals from an IRA.  Also, QCDs don’t require that you itemize, which due to the recent tax law changes, means you may decide to take advantage of the higher standard deduction, but still use a QCD for charitable giving.

[2] A step-up in basis is the adjustment of the value of an appreciated asset for tax purposes upon inheritance. When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The cost basis of the asset is changed to its value at the time of the owner’s death.

[3] A fund’s turnover rate represents the percentage of a fund’s holdings that have changed over the past year, and it gives an idea of how long a manager holds on to a stock.

POSTED IN: blog, Investing

Mark Haser, M.B.A., CFP®, is a Wealth Advisor at Artemis Advisors. His areas of interest include retirement and education planning, risk management, and cash flow management.

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