Asset Location

Asset Location

Asset Location

An additional way that a passive advisor can add value is not just asset allocation but asset location, as shown in the painting below. Specifically, for a client that has a mixture of taxable accounts, traditional IRAs, and Roth IRAs, it is often helpful to construct a single portfolio consisting of multiple asset classes that are divided up among the different accounts with the ultimate purpose of optimizing after-tax returns. Considerations in deciding which asset classes to place in different account types include the following:

1. For Roth IRAs where all the investment growth is tax-free, the preference is to put in the asset classes that have the highest expected returns (which is equivalent to the highest risks). Examples include emerging markets and international small value.

2. For traditional IRAs where current dividends are tax deferred until withdrawal and future withdrawals are taxed as ordinary income (highest tax rate), the best strategy is to include the asset classes that have high dividends and low expected returns. Examples include fixed income, with lower expected returns and high current tax dividends and real estate investment trusts (REITs), with high dividend payouts.

3. For taxable accounts, the best strategy utilizes higher expected return and tax-managed funds whenever possible. Remember that when you sell in a taxable account, the tax treatment is better than the IRA, because long term capital gains tax is generally less than ordinary income tax rates. Examples include tax-managed funds for U.S. large company, U.S. large cap value, U.S. small blend, U.S. small cap value, and international value and emerging markets.

It is important for clients to understand that in an asset located or tax hybrid portfolio, each of the accounts will have very different performance. If the client is not comfortable with this performance difference (e.g., a married couple where the wife’s Roth IRA has a higher expected return than the husband’s traditional IRA), then the tax hybrid portfolio structure may not be appropriate. Furthermore, a good passive advisor will evaluate the purpose of each account to determine if it should be stand-alone or part of a hybrid structure. A special needs trust for a disabled child is an example of an account that should be its own portfolio.

Establishing an asset located or tax-hybrid portfolio is only half of the task; maintaining and rebalancing the portfolio through all types of markets and client cash needs requires the skills that the passive advisor brings to the table. For example, if the client has a cash need from a taxable account, confining the sell trades to the single account may throw the portfolio out of balance. A good advisor will carefully consider how to trade all the accounts in unison with an eye towards tax-efficiency, minimization of transaction costs and maintenance of the client’s designated risk level.

Watch Mark Hebner explain Asset Location on IFA.tv below:

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