Location, Location, Location

June 28, 2007

In real estate, it's all about location, location, location. The same is true when managing your assets.

I’ve written a thing or two about managing risk through asset allocation.  But did you know that managing the location of the assets is nearly as important?  Doing it right is guaranteed to result in greater growth of your portfolio, no matter what crazy ride the market takes us on.  And a guaranteed higher return is something that falls under the “low hanging fruit” category, because it’s such easy pickings.

The “doing it right” I’m talking about is whether you place certain assets classes in taxable versus tax-deferred accounts.  Most people, professionals included, seem to get this backwards.

The logic at play here is that 401(k), IRA, or other tax-deferred accounts are long-term and therefore best suited for equities.  Conversely, the taxable accounts are considered “real money,” and therefore invested more conservatively in bonds or CDs. 

The kink in this logic is that equities, especially low turnover mutual funds, are very tax-efficient, while fixed income and CDs are taxed immediately and at the highest ordinary income rates.  So placing fixed income in the taxable accounts fails to: 

  • Utilize the lower tax rates on qualified stock dividends and long-term capital gains.
  • Defer the taxes on equities for decades, allowing you to earn added returns on money Uncle Sam is letting you hold for a while.

Let’s take a simple example of someone with a $200,000 investment portfolio who wants 50% in fixed income and 50% in stock.  Now let’s assume that half of it is in a taxable account and half is in an IRA.  We’ll also assume the equities will earn 8% annually and the fixed income 6%,.  Finally, let’s say he is in the 28% tax bracket.

If this investor does as most people do and places the fixed income in his taxable account and equities in his IRA, after twenty years, and after paying all taxes, he has amassed $568K.  But, if he reverses the location of those assets, he now has $609K, or $51K more!  Not too shabby considering it was the same amount of risk.

If you’re wondering what the outcome would be if the markets don’t return the same, or if tax rates go up, the answer is that it doesn’t matter.  Under any scenario I can think of, we are always better off to place tax-efficient investments in our taxable account, and tax-inefficient investments in our tax-deferred accounts.

So, where do you go from here?  First, determine how much risk you want to take and build your asset allocation according to that amount of risk.  Then determine where to put the assets.  For your taxable accounts, I suggest low-turnover equity mutual funds and enough cash for emergencies.   For tax-deferred accounts, consider CDs, taxable bonds, REITs, and other investments taxed at the highest rates. 

You may have noticed that I didn’t mention putting municipal bonds in the taxable account.  That’s because it makes absolutely no sense to earn 4% in a muni bond when you could be earning 6% in a taxable instrument placed in your tax-deferred account.  Yet, I see this all the time.

Take my advice and do a little tax re-engineering.  By putting the right assets in the right locations, you’ll guarantee a higher return.  It’s easy once you get there.  Just be sure to watch out for tax landmines, such as the alternative minimum tax, if you create capital gains in your taxable accounts to get to this more efficient position.

 

Assets For Tax Deferred Accounts Assets For Taxable Accounts Assets That Rarely Make Sense

Fixed-Income

Low-Turnover Equity Funds

Municipal Bonds

High-Turnover Equity Funds

Individual Stocks

Insurance Products Taxed As Regular Income At Withdrawal

REITs

   

CDs

   

 

Remember that this advice is for your investment portfolio.  Mark Patterson, a tax partner with Stockman, Kast, Ryan and Company, recommends leaving enough cash in a taxable account for any emergency needs such as medical expenses or loss of employment.  When it comes to the investment portfolio, however, Patterson notes this strategy blends the tax advantages of retirement planning with the current tax laws to generate the biggest return on investments.

There’s an old saying in real estate, that to be successful, it pretty much comes down to location, location, location.  The same goes for investing, since location is also an important component to building wealth.


Roth is a CPA and CERTIFIED FINANCIAL PLANNER. Allan is the founder of Wealth Logic, LLC, an hourly based financial planning and licensed investment advisory firm. He is an adjunct finance faculty member at the University of Colorado at Colorado Springs.  He can be reached at 719-955-1001 or at [email protected]. His firm’s Web site is www.daretobedull.com

This article first appeared in the Colorado Springs Business Journal.

 

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