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Proper Asset Allocation Is Key to Maximizing Portfolios

by Carolyn Walder

What if we were to tell you that managing your portfolio a specific way could earn you more money over the long term without any more risk?  Would you be interested?

This simple trick that anyone can implement is called “asset location,” which essentially is the practice of locating your assets in the most tax-efficient way to maximize your long-term net after-tax returns. A study by the Vanguard Investment Counseling and Research group found that proper asset location of a $1,000,000 portfolio invested in a 50/50 asset allocation to stock and bond funds provided more than $163,000 in additional net return if properly allocated.  Of course there were certain assumptions made in this analysis.  This considered a ten-year time horizon and liquidation of the portfolio after ten years.  Furthermore, a marginal tax bracket of 35% and capital gains rate of 15% was assumed.  Lastly, this scenario assumed that assets were evenly divided between taxable accounts (e.g., joint, individual, trust accounts) and tax-deferred accounts (e.g., IRAs, 401k accounts). Even though this is a hypothetical illustration, the findings are real and will provide investors with a greater portfolio value after Uncle Sam has been paid.  Another study by Morningstar discovered that investors (or their advisors) who paid attention to “tax alpha” could generate another 0.5% return by just correctly locating their investments to maximize net after-tax returns. (This study also summarized the research that has been done to quantify the value of quality investment management and financial advice.  This showed a range of value added of between 1.6% [Morningstar research] to 3.7% [Vanguard research] and as high as 4.2% for research done by Russell Investments.)

How does one go about accomplishing effective asset location? To be most successful at managing a portfolio of assets, there are many factors to consider.  Not only do you need to know what types of asset classes you plan to invest in and the percentages to place in each asset class, you also need to know something about the tax-efficiency of each investment. For the highest after-tax returns, investors should place the investments with the greatest ordinary income tax consequences in tax-deferred accounts like IRAs and 401k accounts.  This would include taxable bonds and bond funds, real estate investment trusts (REITs), and investments that generate significant short-term capital gains (like high turnover mutual funds or active stock trading). Taxable accounts (like revocable trusts, individual brokerage accounts, etc.) should hold those investments that are the most tax-efficient.  This would include tax-efficient stocks and stock funds (i.e., low-turnover, tax managed, and/or funds that focus on capital appreciation rather than paying dividends). Lastly, what about Roth IRAs?  Because you get the benefit of tax-free growth in these accounts, allocating high growth asset classes, such as small cap value and emerging markets, will provide the most long-term growth that can be withdrawn tax-free!

So now that you have properly located your investments in the most tax-wise manner, how do you develop a liquidation strategy once the time comes to start tapping your assets for income?  As a general rule, it makes most sense to start liquidating your taxable accounts first so that you are only paying capital gains on the income that is generated (as opposed to ordinary income tax).   However, if you do not have any other sources of taxable income (such as a pension or taxable social security), then it is smart to take enough income from your IRA to fill up the lower tax bracket(s) (current 12% with the new tax law).  This is because if you continue to defer taxes on your IRA until you are forced to start taking it out at age 70½, you could be required to take more in income than makes sense from a tax perspective and thus pay more in taxes at a later time than if you were withdrawing some each year. 

Lastly, for those who have saved into a Roth IRA, it is best to withdraw from this account last. This is because all the growth in this account will come out tax-free, allowing the tax-free growth to compound over time.  However, there is also another caveat here.  If you are able to closely manage your income to try and stay within a certain income level to reduce your Medicare premiums, it can make sense to draw some tax-free income to avoid going over a threshold level.  However, these circumstances should be closely monitored to avoid withdrawing unnecessarily from these very special accounts!

As many of our clients know, at Lifetime Wealth we are a big proponent of proper asset location as well as appropriate asset allocation that meets a specific client’s goals, objectives, and risk tolerance. Rest assured, if you are a client of LWPM, we are doing the heavy lifting of effective portfolio management for you! As always, if you have questions or concerns, please do not hesitate to contact us.

*If you know someone who may benefit form the information in this article, please feel free to forward it to them. We would be happy to discuss this information!

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