Table of Contents
Asset Location and How You Should
Invest Different Assets in Different Tax Environments
Location, location, location…
by James Lange, CPA/Attorney
I don’t usually write about investments and asset allocation. The model that our firm uses for our assets-under-management clients is to develop financial master plans by “running the numbers” to develop short and long-term strategies.
Then, one of our strategic partners manages the investments. We charge one combined fee that is generally 1% or less, and the money manager and I split the fee. Accordingly, I usually let the money managers write about investments and asset allocation.
I will spare you a basic discussion of asset allocation but would like to bring up a less familiar but extremely critical aspect of managing investments, especially after the passage of the SECURE Act—asset location. All our strategic partners have used the concept of asset location in their practices for years, but since the passage of the SECURE Act, it has become increasingly important. Two of our partners have a similar approach to asset location, and it is not a coincidence that most of their investments are in enhanced index funds with Dimensional Fund Advisors (DFA).
One of our strategic partners is Adam Yofan, Pittsburgh Wealth Advisor for Buckingham Strategic Wealth. When investing money for a client, Adam applies an extremely beneficial strategy known as “asset location” to identify the best type of account to hold a specific investment.
Advice from Adam Yofan at Buckingham Strategic Wealth
There may be no such thing as a free lunch, but proper asset location can come pretty close.
That is not a typo. Asset location is different from asset allocation. Briefly, asset allocation refers to balancing your investment portfolio among different asset classes [i.e., equities (stocks) and fixed income (bonds or CDs)] according to your risk tolerance and investment timeline. Asset location refers to owning the right asset classes in the right types of accounts to take advantage of the tax code.
The current tax code (2021) taxes dividends and capital gains at a lower rate than bond and CD income. It allows for tax deductions for investment losses and provides for a step-up in cost basis at death. For these reasons, equities/stocks (or the mutual funds that own them) should generally be held in taxable accounts. Within a diversified equity portfolio, we prefer large-cap US holdings in taxable accounts.
Asset classes with the highest expected return such as small-cap value, emerging markets, and international markets are best held in Roth IRA accounts, where they will most likely have the longest investment time horizon to capture these higher expected returns. (Remember, growth in Roth accounts is tax-free.)
Conversely, fixed-income assets are best held in retirement accounts like traditional IRAs and 401(k)s because interest income is taxed as ordinary income—which could be higher than the capital gain and dividend rate. Further, the expected return is lower for fixed income than equities, so you’d want to hold fixed income in the retirement account where there is no step-up in basis.
Finally, since short duration/high quality fixed income generally doesn’t fluctuate (or decline as dramatically) over the long term, you don’t expect to harvest losses, which is not allowed within retirement accounts. Other tax-inefficient asset classes (those with high turnover, realized gains, or ordinary income taxed cash flow, etc.) should also be held in retirement accounts.
To highlight the above point, back in March 2020, when the equity markets declined dramatically, holders of stocks in retirement accounts could only watch and wait for their portfolio to come back. Holders of stocks in non-retirement accounts could harvest the loss, stay in the market, and enjoy the same rebound as their counterparts who held stocks in their retirement accounts. And those who held stocks in non-retirement accounts also enjoyed the tax deduction.
Obviously, not every investor owns investments in all of these categories. For example, many of our readers have much more invested in retirement accounts than they have after-tax dollars. So, achieving a perfect asset location strategy can be constrained by the types of assets you hold. But being aware of “tax-efficient” assets vs. “tax-inefficient” assets and locating each type of asset in an account that takes advantage of the current tax code can move you in the direction of a free lunch.
Advice from P.J. DiNuzzo of DiNuzzo Wealth Management
When you develop your investment portfolio(s), you also need to consider their target values vis-à-vis the three primary “Tax Buckets.”
Your “taxable bucket” might be an individual, joint investment account, and/or bank accounts.
Your “tax-deferred bucket” might include an IRA, SEP-IRA, 401(k), 403(b), or other investments where the taxes you pay on the money in those investments are deferred. Your money grows in tax-deferred accounts for a period of time, and once you reach the age of 72, as long as you’re not working for the same organization, you have to take a Required Minimum Distribution (RMD) out of that portfolio per year and pay the taxes on it.
The third, final bucket is the “tax-free bucket,” which might include a Roth IRA or taxable account, for example.
It’s imperative that you diversify your investments across the three tax buckets, and equally important that you properly fund each of them. My experience is that rarely, if ever, do individuals have a knowledge and strategy for this challenge which typically results in overfunding or underfunding each Tax-Bucket by 100’s of thousands of dollars.
Underfunding is obvious, and I’m sure you can appreciate the challenges in underfunding the wrong bucket, but there’s an equal challenge of overfunding the wrong bucket. For example, individuals who have overfunded their tax-deferred bucket and not taken the opportunity to enjoy the benefits of more money in their lifetime, as well as the benefits of being able to leave much more to their children and/or heirs, who may inherit those Roth IRAs in the future.
Advice from Charlie Smith of Fort Pitt Capital Group
The most basic asset “location” advice is, never put investments that are already tax-advantaged (municipal bonds, annuities, etc.) into IRAs or other retirement accounts. It sounds simple, but you’d be amazed at how many times we see this basic rule violated. Next, generally restrict mutual fund holdings to IRA or retirement accounts, while holding your individual stock positions in taxable accounts. When you own a mutual fund, you give up all control of when capital gains are realized and paid, so it’s best to avoid surprises by holding funds in retirement accounts. Conversely, you (or your money manager) can readily accelerate losses and/or defer gains in your taxable individual stock account, so keep your stocks there for more control over taxes. These are just a couple simple rules for boosting your after-tax total return from your overall portfolio – the ultimate investing goal.
In conclusion, asset location represents a potential “free lunch” opportunity to maximize the growth of long-term wealth throughout our individual portfolios by properly implementing tax-efficient strategies.
Investors have two primary aversions: losing money and paying taxes. While we can’t control periodic market declines, we can assuage them through diversification and rebalancing. Similarly, although we can’t ensure that you will never pay taxes, we may be able to minimize them through asset location optimization, tax lot identification, tax-loss harvesting, capital gain harvesting, Roth IRA conversions, and “income smoothing” (tax bracket management). These are significant tax management strategies that have the potential to save you money and add significant value. Through education and quantification, we can get excited about saving money regarding taxes.
Wealth Preservation Solutions for Million-Dollar IRA Owners:
Roth Conversions, Trusts, Investment Strategies & More
These strategies could save you and your family tens, maybe hundreds of thousands, of dollars in taxes…but most financial advisors don’t even think to recommend them.
Tuesday & Wednesday, June 22 & 23, 2021
Register to attend: https://PayTaxesLater.com/Webinars
TUESDAY, JUNE 22, 2021
Session 1: 10:00 am-Noon Eastern
Roth IRA Conversions: Pay Taxes Once and Never Again!
The benefits of a series of well-timed Roth IRA conversions in the appropriate situation could mean tens, or hundreds of thousands, of dollars difference to you and your family. Roth IRA conversions are also often a critical defense against the SECURE Act’s provision that causes a massive tax acceleration on inherited traditional IRAs.
In addition, Roth IRA conversions can reduce estate and inheritance taxes.
This information-packed workshop, with Roth IRA analysis, peer-reviewed and vetted by the American Institute of CPA’s most prestigious tax journal, can help you get more tax benefits from a Roth IRA conversion and more security for your family.
Traditionally, the best time to do a Roth IRA conversion is after you no longer have an income from your job or business, but before you turn 72 when required minimum distributions on top of your Social Security benefits and other income kick in. But our projections prove that when you take into consideration very likely tax rate increases and the SECURE Act, many taxpayers who are still working can benefit from a series of conversions. In addition, IRA owners 72 or older can also benefit.
But that doesn’t mean everyone should be doing large Roth conversions right now. Roth conversions must be evaluated based on an individual’s or family’s unique circumstances. Additionally, factors such as triggering additional premiums on Medicare Part B, the impact on qualified dividend exclusion, capital gains rates, as well as investment income tax rates must be weighed into the calculation.
What You’ll Learn:
- The peer-reviewed math of Roth IRA conversions.
- Optimal timing for Roth IRA conversions.
- The best plan for taking distributions from your retirement accounts.
- Does it make sense to pay for a Roth IRA conversion with a home equity loan?
- The one single decision that can get you bigger Social Security checks.
- The synergistic calculation of optimal Social Security and Roth IRA conversion strategies.
- Using Lange’s Cascading Beneficiary Plan in conjunction for Roth IRA conversions and why our strategies have changed since the SECURE Act.
- Roth IRA conversions and trusts (that will be tied into tomorrow morning’s session).
Session 2: 1:00pm – 3:00 pm Eastern
Live Q&A with James Lange: Ask Me Anything!
Jim will answer attendees’ questions submitted in advance of the webinar as well as during the webinar. This is a golden opportunity to get straight—and personalized—answers to your most perplexing retirement questions. What haven’t you thought of? Learn even more from listening to the questions and answers from others who are in similar circumstances.
WEDNESDAY, JUNE 23, 2021
Session 3: 10:00 am-Noon Eastern
Who Says You Can’t Control from the Grave? Using Trusts to Protect Your Family.
Trusts can ensure your hard-earned money is handled responsibly, long after you are gone. Perhaps you are worried about creditors destroying your legacy. Unfortunately, the ex-spouses of your children can be the fiercest creditors jeopardizing an inheritance from you. Trusts can stop them dead in the water!
Most trusts that we examine when the underlying asset is an IRA and retirement plan are botched. Bad trusts can trigger a massive acceleration of income taxes after your death if they don’t meet five specific conditions. Yet many attorneys don’t include those provisions in their trusts. Those omissions could cost beneficiaries tens or even hundreds of thousands of dollars.
What You’ll Learn:
- Should your heirs inherit your IRA directly, or would naming a trust be safer?
- Is it worth the aggravation of creating and administering a trust after you are gone?
- Is trust planning still appropriate for your family and which trusts should you use?
- Is the “I don’t want my no-good son-in-law to inherit one red cent of my money” trust right for you?
- Trusts for minors.
- Spendthrift trusts — how to protect adult children from their own bad judgment and creditors.
- Trusts for special needs beneficiaries. The SECURE Act offers protection for beneficiaries with disabilities or chronic illnesses if the trust is drafted properly.
- The SECURE Act changes the type of trust we recommend for IRA owners.
- The pros and cons of avoiding probate.
- Lange’s Cascading Beneficiary Plan — how to integrate trusts into the best and most flexible estate plan for married couples.
Session 4: 1:00pm – 3:00 pm Eastern
Live Q&A with the Dream Team: Larry Swedroe, Adam Yofan of Buckingham Strategic Wealth, and James Lange Answer Your Questions on Investing and Wealth Management and Preservation
Who doesn’t have investment questions? Larry, Adam, and Jim will answer attendees’ questions submitted in advance of the webinar as well as during the webinar. Take advantage of this golden opportunity to have your most nagging investment questions answered.
Larry Swedroe, Chief Research Officer of Buckingham Strategic Wealth, educates individuals on the benefits of evidence-based investing. Larry has authored nine books and co-authored seven books on investing, including his newest book, Your Complete Guide to a Successful & Secure Retirement. Larry has made appearances on NBC, CNBC, CNN, and Bloomberg Personal Finance.
Adam Yofan, CPA, PFS, leads Buckingham’s Pittsburgh office. Adam navigates clients toward financial clarity by defining goals and needs, reviewing assets, providing recommendations, implementing and managing portfolios, and tracking progress as they pursue well-defined goals.
Register today at: https://PayTaxesLater.com/webinars
Past performance is no guarantee of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee that any strategy will be successful. Indexes are not available for direct investment.